JIMMA UNIVERSITY

CONTINUING AND DISTANCE EDUCATION

MODULE
ON

LABOR ECONOMICS
(FOR DISTANCE LEARNERS)

MODULE WRITERS:
HASSEN ABDA (M. Sc.)
FIKRU GEZAHEGN (M. Sc.)

MODULE EDITOR:
WONDAFERAHU MULUGETA (M. Sc.)

JULY 2010
 TABLE OF CONTENTS
Page
UNIT ONE: INTRODUCTION TO THE COURSE .......................................................... 1
1.1 WHAT IS LABOR ECONOMICS? .............................................................................. 1
1.2 UNIQUE CHARACTERISTICS OF THE LABOR MARKET .................................... 4
1.3 CRITICISMS OF LABOR ECONOMICS AND RECENT RESEARCH .................... 5

UNIT TWO: THE SUPPLY OF LABOR ............................................................................ 8

SECTION ONE: BASIC CONCEPTS AND MEASUREMENTS OF AGGREGATE
LABOR SUPPLY ............................................................................... 9
1.1 Measuring Labor Supply .......................................................................................... 9
1.2 Difficulties in Estimating Labor Supply ................................................................. 13
1.3 Activity Rate (Participation Rate)........................................................................... 14
1.4 Job Attachment and Participation Rate ................................................................... 14
1.5 Business Cycle and Participation Rate ................................................................... 15
1.6 Activity Rates in Ethiopia ....................................................................................... 16
SECTION TWO: THE THEORY OF INDIVIDUAL LABOR SUPPLY ........................ 18
2.1 The Basic Neoclassical Model of Labor Supply: The Labor-Leisure Tradeoff ..... 18
2.2 Non-Labor Income and Labor Supply .................................................................... 29
2.3 Income Replacement Programs and Labor Supply................................................. 31
2.4 Welfare Programs and Labor Supply...................................................................... 33
2.5 A Standard Work Day and Labor Supply ............................................................... 38
2.6 Premium Wages and Straight Line Equivalents ..................................................... 40
SECTION THREE: THE MARKET SUPPLY OF LABOR AND THE ELASTICITY OF
LABOR SUPPLY ............................................................................. 43
3.1 The Market Supply of Labor .................................................................................. 43
3.2 The Elasticity of Labor Supply ............................................................................... 45

UNIT THREE: THE DEMAND FOR LABOR ................................................................ 50

SECTION ONE: THE DEMAND OF A FIRM FOR LABOR IN THE SHORT RUN .... 51
 1.1 Perfect Competition in Both the Product and Labor Markets ................................ 51
1.2 Monopolistic Power in the Product Market ............................................................ 54
SECTION TWO: THE DEMAND OF A FIRM FOR LABOR IN THE LONG RUN ..... 57
2.1 Perfect Competition in Both the Product and Labor Markets ................................ 57
2.2 Monopolistic Power in the Product Market ............................................................ 61
SECTION THREE: THE MARKET DEMAND FOR LABOR AND ELASTICITIES OF
LABOR DEMAND .......................................................................... 62
3.1 The Market Demand for Labor ............................................................................... 63
3.2 The Elasticities of Labor Demand .......................................................................... 65
3.3 Elasticity of Factor Substitution ............................................................................. 68

UNIT FOUR: LABOR MARKET EQUILIBIRIUM ....................................................... 75

SECTION ONE: WAGE DETERMINATION UNDER DIFFERENT PRODUCT AND
LABOR MARKETS ........................................................................ 76
1.1 Wage Determination under Perfectly Competitive Product and Labor Markets .... 76
1.2 Wage Determination and Monopolistic Exploitation ............................................. 78
1.3 Wage Determination and Monopsonistic Exploitation ........................................... 79
1.4 Bilateral Monopoly ................................................................................................. 83
1.5 A Labor Union Facing Perfectly Competitive Firms …………………………… 85
SECTION TWO: LABOR UNION AND MINIMUM WAGE LAWS ............................ 88
2.1 Labor Unions and the Union Wage Advantage ...................................................... 88
2.2 Minimum Wage Laws ............................................................................................ 94
SECTION THREE: WAGE THEORIES AND WAGE PAYMENT SYSTEMS …..… 97
3.1 Theories of Wage ……………………………………………………………...…97
3.2 Wage Payment Systems ……………………………………………………….... 99

UNIT FIVE: WAGE DIFFERENTIALS AND LABOR QUALITY ............................ 108

SECTION ONE: WAGE DIFFERENTIALS .................................................................. 109
1.1 What Is Wage Differential .................................................................................... 110
1.2 Wage Differentials Due to Heterogeneous Jobs ................................................... 110
1.3 Wage Differentials Due to Heterogeneous Workers ............................................ 112
 1.4 Wage Differentials Due to Labor Market Imperfections ...................................... 113
SECTION TWO: LABOR QUALITY ............................................................................ 115
2.1 Investment in Human Capital ............................................................................... 115
2.2 On-the-job Training .............................................................................................. 123
2.3 The Cobweb Model of Educational Attainment ................................................... 126
2.4 Criticisms of the Human Capital Theory .............................................................. 131

UNIT SIX: JOB SEARCH AND UNEMPLOYMENT .................................................. 136

SECTION ONE: JOB SEARCH ...................................................................................... 137
1.1 What Is Job Search? .............................................................................................. 138
1.2 External Job Search .............................................................................................. 139
1.3 Internal Labor Markets and Job Search ................................................................ 141
SECTION TWO: UNEMPLOYMENT ........................................................................... 143
2.1 Definitions and Measure of Unemployment ......................................................... 143
2.2 Types of Unemployment ...................................................................................... 147

ANSWERS TO SELECTED REVIEW QUESTIONS ................................................... 154

REFERENCES ................................................................................................................... 155
 UNIT ONE
INTRODUCTION TO THE COURSE

Unit Introduction

This is a course in the economics of labor markets. Labor economics encompasses many of
the most important issues in economics. Most people earn most of their income by selling
their labor time. So labor economics deals with the major source of personal income, what
determines it, and why it may differ for different individuals. It also deals with the allocation
of the most important (in value terms) input into the production process.

Unit Objectives

After learning the material in this unit, the student should be able to:
 explain what labor economics is all about and why it is justified as a special field of
inquiry;
 describe how the economic perspective can be applied to analysis of labor markets;
 list and explain the basic assumptions underlying the choice-theoretic approach to
labor economics identify those topics in labor economics that are mainly
microeconomic and those that are primarily macroeconomic; and
 describe the benefit that to be derived from understanding labor economics.
 discuss how the scope of and the approach to labor economics have changed over
time.

1.1 WHAT IS LABOR ECONOMICS?

Labor economics is the study of the workings and the outcomes of the market for labor. It
seeks to understand the functioning of the market and dynamics for labor. Labor markets
function through the interaction of workers and employers. Labor economics looks at the

1
suppliers of labor services (workers), the demanders of labor services (employers), and
attempts to understand the resulting pattern of wages, employment, and income.

We are studying the economics of the labor market, but what exactly is “the labor market”?
We can define it simply as all the buyers and sellers of labor services, and the institutions
that facilitate that buying and selling. In fact the labor market consists of many markets.
Labor markets differ in terms of location, occupation, and skill. A labor market tends to be
more like a single market to the extent that there is a high degree of mobility within it. The
question that follows is: what are labor services? Labor services are the direct input of
human muscle and brainpower into production. Obviously this is very broadly defined, and
includes many occupations and tasks.

Labor economics is primarily concerned with the behavior of employers and employees in
response to the general incentives of wages, prices, profits and non pecuniary aspects of the
employment relationship (such as work environment, risk of injury, personality of managers,
flexibility of work hours, etc). It examines:
 the organization, functioning and outcomes of labor markets,
 the decision of prospective and present labor market participants, and
 the public policies relating to employment and payment of labor resources.

The justification for labor economics to be studied as a separate discipline is reflected in

three areas: current socioeconomic issues and problems, the quantitative dominance of labor
as a resource, and the unique characteristics of labor supply and demand. In the first set – the
current socioeconomic issues and problems – are included issues such as gender and race
discrimination, legal and illegal immigration, unionization, and free trade. Its quantitative
importance is reflected in that the largest share of national income goes to labor in most
countries. Institutional factors including unions, licensing, minimum wage and
discrimination are of particular concern to labor market participants.

2
Labor economics is an important subject because unemployment is a problem that affects
the public most directly and severely. Full employment (or reduced unemployment) is a goal
of many modern governments. An understanding of the content and analytical tools of labor
economics contributes to more intelligent personal and social decisions.

Before three decades or so labor economics was highly descriptive, emphasizing historical
developments, facts, institutions, and legal considerations. This approach – called the “Old”
labor economics – involved little economic analysis.

This orientation has changed significantly in recent decades. The “New” approach uses
applied microeconomic and macroeconomic theories. Labor economics, therefore, can
generally be seen as the application of microeconomic or macroeconomic techniques to the
labor market.

Microeconomic techniques study the role of individuals in the labor market. Macroeconomic
techniques look at the interrelations between the labor market, the goods market, the money
market, and the foreign trade market. It looks at how these interactions influence macro
variables such as employment levels, participation rates, aggregate income and Gross
Domestic Product.

Labor economics uses theories of choice to explain behavior of labor market participants
and resulting outcomes. Choice theories rest on three assumptions: relative scarcity,
purposeful behavior, and adaptability. Resources – labor, capital, land and entrepreneurial
ability – are limited (scarce) relative to the many individual and collective wants of society.
Because of scarcity, we are forced to make choices and choices involve giving something
up. Such a sacrifice is termed an opportunity cost. Consequently, economic agents are
assumed to make choices based on net gain or expected net gain (after comparing costs and
benefits) – that is, individuals (and firm) make choices purposefully or rationally. Lastly,
workers and firms adapt their behaviors in response to changes in expected costs and
benefits.

3
 Section Reflection

1. What is labor economics is all about? Which of these issues are microeconomic in
nature and which are macroeconomic?
2. Discuss how the fundamental concepts of scarcity, opportunity cost, and rationality are
related to decision making of an individual in the labor market.

1.2 UNIQUE CHARACTERISTICS OF THE LABOR MARKET

The labor market is like other markets in that a commodity (labor services) is bought and
sold. It differs from most product markets in several important ways. The complexity of the
labor markets emanating from the markets‟ peculiar characteristics imply that the concepts
of supply and demand must be substantially revised or reoriented when applied to labor
markets. This is also one justification for labor economics to exist as a separate field of
study.

The following are among the distinctive characteristics of the labor market:
 Labor services are rented, not sold. In this sense, labor services are distinct from the
other major types of inputs, such as raw materials or capital, where we have a
physical transfer of those resources from the seller to the buyer.
 Labor supply decisions are more complex than that applies to product markets.
Because labor service cannot be separated from workers, the suppliers of labor care
about the way in which the labor is used. Non-monetary factors like job safety,
stability of employment, opportunity for training and advancement are significant in
employment transactions.
 Labor productivity is affected by pay and working conditions.
 On the demand side, the demand for labor is a derived demand – derived from the
demand for the products it produces. While the demand for a product is based on the
satisfaction or utility it yields, labor is demand for its contributions in creating goods
and services (which are demanded).

4
 Section Reflection

1. How does the supply side of the labor market differ from that of a product market?
2. What do we mean by demand for labor is a derived demand?

1.3 CRITICISMS OF LABOR ECONOMICS AND RECENT

RESEARCH

One critique of standard economic analysis of labor markets is that it does not account for
the importance of social networks in the employment process. This view holds that personal
connections are key issues for both workers and employers. Hence, employees are more
likely to apply for jobs where they have a personal connection and are more likely to be
hired if they apply. More generally, sociologists and political economists claim that labor
economics tends to lose sight of the complexity of individual employment decisions. These
decisions, particularly on the supply side, are often loaded with considerable emotional
baggage and a purely numerical analysis can miss important dimensions of the process.

In response to this issue, a large literature has recently evolved that attempts to identify
statistical discrimination in hiring, looking at whether group membership, most notably race,
influences firms' hiring decisions.

Also missing from most labor market analyses is the role of unpaid labor. Even though this
type of labor is unpaid it can nevertheless play an important part in society. The most
dramatic example is child-raising, a work which is performed by family members without
pay. Such work is not paid for in a market, but it may have important implications for
people‟s behavior in markets for paid labor, because it constitutes an alternative use of a
person‟s time.

However, over the past 25 years an increasing literature, usually designated as the
Economics of the Family, has sought to study within household decision making. These

5
within the household decision making include joint labor supply, fertility, child-raising, as
well as other areas of what is generally referred to as home production.

Section Reflection

1. What points have been used in forwarding criticisms on labor economics?

2. What responses did they get? Discuss!

Unit Summary

1. Labor economics studies the organization, functioning and outcomes of labor markets;
the decision of prospective and present labor market participants; and the public policies
relating to employment and payment of labor resources. It is an important subject
because unemployment is a problem that affects the public most directly and severely.
Labor economics – in the “New approach” – uses theories of choice (which rest on the
assumptions of relative scarcity, purposeful behavior, and adaptability) to explain
behavior of labor market participants and resulting outcomes.

2. Labor market differs from most product markets in several important ways. The
complexity of the labor markets emanating from the markets‟ peculiar characteristics
imply that the concepts of supply and demand must be substantially revised or
reoriented when applied to labor markets.

3. In the past, labor economics has been criticized on the grounds that it does not account
for the importance of social networks in the employment process, and that it ignores the
role of unpaid labor. These criticisms have led to growth in the scope/coverage of the
discipline over time.

6
Review Questions

Answer Each of the Following Questions

1. Why must the concepts of supply and demand as they pertain to products be modified
when applied to labor markets?
2. Suppose you are concerned with deciding how much labor to supply for work. In
making your decision,
a. what resource is scarce?
b. how is the issue of opportunity cost relevant to you decision?
c. Briefly explain features that are peculiar to the labor market?

7
 UNIT TWO
THE SUPPLY OF LABOR

Unit Introduction

In labor market, as in any market, we are interested in quantity and price. We postpone the
issue of price to a later unit, and take up the issue of quantity here. The quantity is the
amount of labor input, typically measured in number of workers and/or amount of labor time
(say worker hours). We start with some simple definitions relating to the quantity of labor:
1. how many workers are there in the market? This is the question of the labor market
status of the population.
2. how much labor does each worker supply? This is the question of hours of labor.

Unit Objectives

Throughout this unit, we will respond to the above questions touching upon some basic
concepts and principles. Hence, after thoroughly going through this unit, you students are
expected to:
 understand how the status of labor in an economy is supplied and the problems faced
in putting the principles into practice;
 describe how the supply of labor by an individual is derived from the leisure-work
trade of and how such a decision is affected by different programs and arrangements
(using the neoclassical framework);
 figure out the importance of substitution and income effects of a wage change in
shaping the supply of labor curve;
 discuss how the market supply of labor is derived from the supply of labor by
individuals; and
 comprehend the concept of elasticity of labor supply.

8
SECTION ONE: BASIC CONCEPTS AND MEASUREMENTS OF
AGGREGATE LABOR SUPPLY

Section Overview

SECTION ONE: BASIC CONCEPTS AND MEASUREMENTS OF

LABOR SUPPLY (FOR AN ECONOMY)

1.1 Measuring Labor Supply

1.2 Difficulties in Estimating Labor Supply

1.3 Activity Rate (Participation Rate)

1.4 Job Attachment and Participation Rate

1.5 Business Cycle and Participation Rate

1.6 Activity Rates in Ethiopia

1.1 Measuring Labor Supply

For the economy as a whole, the concept of labor supply has many dimensions. The
aggregate of labor services available to a society depends on:
 the size and demographic compositions of the population, which in turn depends on
births, deaths, and immigrations;
 the labor force participation rate (activity rate);
 the number of hours worked per week or per year; and,
 the quality of the labor force.

9
 BIRTHS

POPULATION
DEATHS

LABORFORCE QUANTITY
NET
PARTICIPATION OF
IMMIGRATION
RATE LABOR TOTAL
LABOR
SERVICES
HOURS OF QUALITY
AVAILABLE
WORK OF
LABOR

Figure 2.1: Determinants of the Total Labor Services Available

The above figure summarizes the determinants of the total quantity of labor services
available to a society.

The size of the total population (head count) is sometimes used as a measure of labor
services available to a society. However, this measure is defective since it includes the
underage children and the elderly.

A better measure is the working age population. This excludes the underage children and the
elderly. Nevertheless, it suffers from criticisms because it includes the disabled people and
college students, imprisoned people … who are not contributing or trying to contribute their
labor services to the society.

10
 A still better measure of labor market status is the labor force. This comprises of people in
the working age who are employed, or unemployed but actively seeking work or expecting
recall from layoff. Everyone else is not in the labor force. The problem with this is it does
not take account of the issue of productiveness (quality).

The (theoretically) best measure is the manpower. Manpower contains the essential elements
of labor supply such as education, skill, training, experience, etc and hence it is the best
approximation of labor supply. However, because of the difficulty in measuring job efforts
and productiveness (which are unobservable), the labor force is the one commonly used.

Figure 2.2 below summarizes the various measures of labor services available to a society
that we discussed in the foregoing paragraphs.

Population Size Working-age

Population Labor force
(Head count)
 Disabled  “Productiveness”
 Under- age MANPOWER
people, – relation with
children, the  practicability
college output??
elderly??
students??

Figure 2.2: Different Measures of Labor Market Status

Note that:
 Whatever measure of labor supply is used, the reference period (whether a weak, or a
month, or a year …) is an important dimension that should be disclosed.
 Whatever measure of labor supply is used, the shorter the reference period, the more
credible the statistic is.

11
 Labor Supply Framework

Total
population

Working-age Population outside

Population the Working-age

Labor Force
Population Not
(Currently Active
Currently Active
Population)

Employed Unemployed

In Paid Standard Modern

In Self
Employment Definition Definition
Employment

At work With a job At work for With an Without work,

Without work,
for wage but not at profit or enterprise currently
currently
or salary, work family gain, but not at available for work
available for
in cash or (formal job in cash or in work and seeking work
work (in paid or
in kind attachment) kind (in paid or self) self)
But not seeking
Figure 2.3: The Labor Supply Framework work

12
The “seeking work” criterion is dropped in the modern (modified) definition of
unemployment which is applicable in developing countries (LDCs) characterized by the
following situations:

 The labor force is largely self employed;

 The labor market is not well-organized (is disorganized); and

 Conventional means of job search are of limited relevance.

1.2 Difficulties in Estimating Labor Supply

The estimates provided by the approach commonly adopted (the labor force approach), like
the concept and measurement of labor supply, cause many problems. The reasons why this
approach fails to achieve wholly satisfactory approximation of labor supply include the
following:

 The concept of labor supply encompasses notions which go beyond the number of
people in the labor force like hours of work, effort on the job, …

 The reference period also affects the estimated labor supply. For instance, census of
short reference period conducted during the slack seasons underestimate labor supply
while it overestimates if it is conducted in peak seasons.

 The measurement of labor supply is difficult when the frequency of economic status
change is high; i.e., it overestimates or underestimates labor supply if large
proportions of the population are in and out of the labor force count too frequently.

 It is difficult to identify and measure comprehensively the level of economic

activities. This problem is more serious in the least/less developed countries where a
large proportion of production is non-marketable.

 It is difficult (not always possible) to categorize activities as economic and non-

economic. Is begging (using “washint” (flute) an economic or a non-economic
activity?

13
The labor force approach should be refined or improved by using complementary methods
of estimation. Time-use surveys, labor efficiency approaches can supplement the labor force
framework to produce a relatively more efficient measure of labor supply.

1.3 Activity Rate (Participation Rate)

Activity rate measures the extent of involvement in economic activities, or the level of
participation in the production and/or distribution of economic goods and services.

That is,

 Activity Rate  Labor Force

( Labor Force Participat ion Rate )  Working-age Populati on  100
 
Or

 Activity Rate  Actual Labor Force

( Labor Force Participat ion Rate )  Potential Labor Force  100
 

Participation rates differ from society to society or for different segments within a society.
The factors which contribute to such differences in activity rates include: gender (male vs.
female participation rates), culture, level of development. The most powerful are the
individual‟s job attachment and the business cycle.

1.4 Job Attachment and Participation Rate

Based on the nature of their job attachment, workers may be grouped as: primary workers
and secondary workers.

Primary workers – these are workers who maintain permanent attachment to the labor force
until retirement. In spite of small changes in the wage rate and working conditions, they tend
to remain in the labor force as an employed or an unemployed person. An example is male

14
household heads that remain in the labor market (working or looking for some job)
regardless of the situation prevailing in the labor market.
Secondary workers – these are workers who have highly valued options to market work and
thus their attachment to the labor force is of a lower degree (as compared to primary
workers). To induce these workers to increase their participation in the labor market, the
income/earning differential between market work and the non-market option/work has to be
raised significantly. Examples of secondary workers include married women with children
(who have the options of home making and market work) and students of working age who
have the alternatives of going to school and dropping out to earn income.

Therefore, it can be concluded that, ceteris paribus, primary workers have relatively higher
labor force participation rates than secondary workers.

1.5 Business Cycle and Participation Rate

Labor force participation rates, whether for primary or secondary workers, are also affected
by the business cycle. The effect of the business cycle (fluctuations) on labor force
participation rates depends on the relative strength or size of two opposing forces: the added
worker effect and the discouraged worker effect.

According to the added worker hypothesis, participation rates tend to rise during economic
recessions and fall during periods of economic prosperity. This is explained by household
members – particularly secondary workers – entering and leaving the labor market during
recession and prosperity, respectively, to maintain family income. This implies that labor
force participation rate moves counter-cyclically and hence tends to stabilize employment.
That is, it protects unemployment from rising (or at least from rising as much as it could)
during recession, and unemployment from falling in booms.

To the contrary, the discouraged worker hypothesis predicts that during a recession some
unemployed individuals (who have been in the labor force) become so pessimistic about

15
finding a job with an acceptable wage rate that they cease to actively seek employment and
thereby become non-participants. Discouraged workers are workers who have given up
looking for work. In addition, potential work force is also deterred from entering the labor
market.
Ceteris paribus, participation rate moves counter-cyclically if the added worker effect is
greater than the discouraged worker effect and vice versa. That is, participation rate rises
during recessions (and falls during booms) if the added worker effect is greater than the
discouraged worker effect.

1.6 Activity Rates in Ethiopia

Compared to a profile of a typical developed economy, the Ethiopian activity rates are
relatively higher for each age group, and the activity rate differentials are most marked for
the extreme age groups.

Activity Rate
Activity Rate for
Ethiopia

Activity Rate
for a Developed
Economy
The Middle
The Youth The Elderly
Age

Age Group

Figure 2.4: the Participation of Ethiopia as Compared to that of a Typical Developed

Country

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Factors accounting for the relatively higher participation rate among the youth in Ethiopia
(in LDCs in general) include:
 The dominance of family and self employment;
 The subsistence or traditional nature of the economy;
 Low level of social infrastructure (like child care and schools);
 Absence of or unimplemented child protective laws; etc.

The main factors accounting for the relatively higher participation rate among the elderly
are:
 Low wage income (low savings during earlier ages);
 Low level of development of non-wage income sources; and
 The inadequacy of non-traditional social security systems (the pensions scheme for
public sector employees constitutes the only social security system in Ethiopia).

In addition, the Ethiopian Data (the 1984 census) show that:

 For each age cohort, male participation rates are higher than female participation
rates;
 For each age cohort, participation rates are higher in the rural than in the urban;
 Participation rates are higher for married (female/male) than for the unmarried
(social variables influence participation rates); …

Section Reflection

1. Discuss the factors which determine the total labor services available to a society and
indicate the difficulties involved in estimating the size of labor supply.
2. Explain how each of the factors listed in this section have made the participation rate of
the youth and the elderly in Ethiopia greater than that of a developed country.

17
SECTION TWO: THE THEORY OF INDIVIDUAL LABOR SUPPLY

Section Overview

SECTION TWO: THE THEORY OF INDIVIDUAL LABOR SUPPLY

2.1 The Basic Neoclassical Model of Labor Supply:

The Labor-Leisure Tradeoff

2.2 Non-Labor Income and Labor Supply

2.3 Income Replacement Programs and Labor Supply

2.4 Welfare Programs and Labor Supply

2.5 A Standard Work Day and Labor Supply

2.6 Premium Wages and Straight Line Equivalents

2.1 The Basic Neoclassical Model of Labor Supply: The Labor-Leisure Tradeoff

2.1.1 Assumptions Underlying the Model

1. There are only two possible uses of time: labor and leisure.
2. Each individual selects the combination of hours of work and leisure that maximizes his
or her level of satisfaction (utility).

Given these assumptions and the basic economic concepts of opportunity cost and choice,
 For individuals who are working, the opportunity cost of an additional hour of
leisure time is the (market) wage rate.

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  An individual will choose not to work if the value he/she places on leisure time
exceeds the market wage.

2.1.2 Constrained Optimization

Let's examine how indifference curves and budget constraints may be used to illustrate the
optimal combination of labor and leisure. An indifference curve is a graph of alternative
combinations of goods that provide a given level of satisfaction (utility). In the simple
neoclassical model of labor supply, it is assumed that the individual's utility level is a
function of two goods: real income (Y), and leisure time (L).

In mathematical terms, this utility function may be expressed as:

U  f ( L, Y )
where U = the level of utility associated with alternative combinations of L and Y.

An alternative way to the utility function is to use indifference curves. An indifference curve
provides a graph of all of the combinations of income and leisure that provides a given level
of utility to an individual. An indifference map is the set of possible indifference curves in
the L-Y plane.

We will make use of the so-called well-behaved indifference curves. These indifference
curves have the following features.
 An indifference curve is downward sloping because an individual is willing to give
up some income to receive an additional unit of leisure (or vice versa). If the
individual consumes less of one good, he/she has to be compensated by consuming
more of the other good, if his/her level of satisfaction is to remain the same.
 All the combinations of real income and leisure represented by points on the same
indifference curve yield the same level of satisfaction.
 Points that lie above and to the right of an indifference curve provide a higher level
of utility than points on the curve.

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  There is an imperfect substitutability (assumed) between real income (Y) and leisure
(L). That is, the marginal rate of substitution of leisure for income (MRSL,Y) declines
as one has more and more of leisure. MRSL,Y is defined as the amount of income that
the individual is willing to sacrifice for an extra unit of leisure, holding utility
dY
constant. That is: MRS L ,Y   dU 0 . This is the absolute value of the slope of
dL
the indifference curve.

U3 > U2 > U1

U3
U2
U1
L
Figure 2.5: The Indifference Map

Individuals attempt to achieve the highest possible level of utility. The choice among
alternative levels of Y and L, however, is restricted due to two constraints:

1. a time constraint, and

2. a goods constraint.

The time constraint is given by:

H + L = T ………………………………………………………...……………… (1)

20
where:
H = hours of work
L = hours of leisure
T = Total time

This time constraint simply notes that time spent at work plus time spent at leisure must add
up to the total time available (since these are the only two uses of time in this model).

Using the definitions of H, L and T above along with w = wage rate, p = price index for real
income, Y = real income, the goods constraint is given by:
pY = wH ………………………………………………………..………………… (2)

This equation states that total spending (pY) must equal earnings (= wH). (Since this is a
one-period model, saving and lending do not occur. More complex models that include this
possibility have results that do not differ substantially from those derived below in this
simpler model. The analysis of more complex multi-period models, however, requires
mathematical tools that are beyond the scope of this course.)

Rewriting equation (1) as: H = T – L and substituting this into equation (2) results in:
pY = w(T – L)
With a little algebraic manipulation, this becomes:
wT = pY + wL ……………………………………...…………………………….. (3)
This equation is called a "full-income constraint." Economists define full income as an
individual's maximum earnings potential (= wT in this case). This equation states that full
income equals the total explicit costs of goods and services (pY) plus the total implicit cost
of leisure time (wL).

An alternative form of equation (3) is given by:

w w
Y  ( ) L  ( )T ….…………………………..…………………………….(4)
p p

21
This equation describes the relationship that exists between hours of leisure and real income.
Equation (4) is the individual's budget constraint.

The intercept of the budget constraint on the horizontal axis equals T (found by substituting
Y = 0 into equation (4)). This is the maximum amount of leisure time that an individual can
receive. Noting that the budget constraint contained in equation (4) is expressed in slope-
wT
intercept form, the intercept of the budget constraint on the vertical axis equals (or this
p
can be found by substituting L = 0 into equation (4)). This is the real value of full income.
Using the slope-intercept form of the budget constraint in equation (4), we can also see that
w
the slope of the budget constraint equals  .
p

The diagram below illustrates the budget constraint facing this individual.

Y wT
p
w
Slope = 
p

0
L T
0
T H

Figure 2.6: The Full Budget Constraint of an Individual

22
In the diagram below (Figure 2.7), three indifference curves have been added to the diagram
containing the budget constraint. Each point on the budget constraint is a feasible
combination of income and leisure. It is assumed that the individual will select the
combination of income and leisure that provides the highest possible level of utility.

As indicated by the diagram below, this optimal combination of L and Y occurs at a point of
tangency between the budget constraint and an indifference curve. In the diagram, this
optimal point occurs when real income equals Y* and hours of leisure equals L*. At this
point, the individual chooses to work H* hours.

Y*

l* L*
0
H* T
L
0
T H

Figure 2.7: Equilibrium of an Individual

23
2.1.3 Substitution and Income Effects of a Wage Change

A change in the wage results in two effects on an individual's labor supply:

 a substitution effect, and
 an income effect.

As the wage rate rises, the opportunity cost of leisure time rises. In response to this higher
wage rate, the individual consume less leisure time and spend more time at work (even at the
same level of satisfaction). This is the substitution effect resulting from a higher wage.

An increase in the wage, however, also raises an individual's real income. This leads to an
increase in the consumption of all normal goods. Since leisure is expected to be a normal
good for most individuals, a higher wage will generally induce the individual to consume
more leisure time (and reduce hours of work). Individuals who receive a higher wage can
afford to take more time off from work. This is the income effect resulting from a wage
increase.

24
 Y
w1T
p

w0T
p

B C
A
U1
U0

0 T L
T 0 H

Figure 2.8: The Substitution and Income Effects of a Wage Fall

In the figure:
 Movement from point A to B is a substitution effect. (utility is held constant at U0).
 Movement from point B to C is a pure income effect. Leisure rises as real income
rises in response to the higher wage.

If we assume that leisure is a normal good, an increase in the wage will cause the quantity of
labor supplied to:
 increase if the substitution effect is larger than the income effect, and
 decrease if the income effect is larger than the substitution effect.

This may result in a backward-bending labor supply curve (as illustrated below).

25
 Wage Labor Supply

Substitution Income
Effect
< Effect

Substitution Income
Effect
> Effect

Quantity of Labor

Figure 2.9: Labor Supply by an Individual

In the diagram above, it is supposed that, at relatively low wages, the individual responds to
an increase in the wage by working additional hours (since the substitution effect exceeds
the income effect). Eventually, though, when the wage becomes sufficiently high, the
individual will begin to work less in response to a higher wage rate. (In practice, it appears
that most labor supply curves are either upward sloping or vertical.)

2.1.4 Reservation Wage

The absolute value of the slope of an indifference curve is a measure of the opportunity cost
of time at that point. Note that the absolute value of the slope of an indifference curve serves
as a measure of the amount of income that is required to induce the worker to give up an
hour of leisure time. A steep indifference curve indicates that a large change in income is
required to induce an additional hour of work; a relatively small increase of income can
induce an additional hour of work when indifference curves are relatively flat. Thus,

26
indifference curves are relatively steep when the value of time in non-market activities is
relatively high. The diagram below contains a set of indifference curves for an individual
who places a high value on non-market time.

A corner solution occurs when the indifference curve is steeper than the budget constraint
at the point corresponding to zero hours of work. This possibility is illustrated in the
diagram below. A careful inspection of this diagram should indicate that the highest possible
level of utility (given this budget constraint and these preferences) occurs at zero hours of
work. An individual chooses to remain out of the labor force when a corner solution such as
this occurs.

Y U0 U1 U2 U3

wT
p

0 T L
T 0 H

p p p
p
Figure 2.10: A Corner Solution to Utility
p Maximization
p

A corner solution at zero hours of work will occur when the value of leisure time is
relatively high and/or the market wage is relatively low. To see this, note that the absolute
value of the slope of the indifference curve is a measure of the opportunity cost of leisure
time while the absolute value of the slope of the budget constraint is the real wage. A corner
solution occurs only if the value of leisure time (the absolute value of the slope of the

27
indifference curve) exceeds the real wage (the absolute value of the slope of the budget
constraint).

The absolute value of the slope of the indifference curve at the point corresponding to zero
hours of work is the individual's reservation wage (expressed in real terms).

If the real wage in the labor market exceeds the reservation wage, the individual chooses to
work. This possibility is illustrated in the diagram below. Notice that when the real wage
exceeds the reservation wage, there are feasible points on the budget constraint that provide
a higher level of utility than would occur at zero hours of work.

Y U0 U1 U2 U3

Budget constraint
|slope| = real wage

|slope| = Reservation
Wage

0 T L
T 0 H

p p p
Figure 2.11: Reservation Wage Less Than Market Wage,
p Positive Quantity of Labor
p p
Supplied

If the real wage in the labor market is less than the reservation wage, the individual chooses
to remain out of the labor force and a corner solution occurs. This possibility is illustrated in
the diagram below.

28
So, whenever the market wage exceeds the reservation wage, an individual will choose to
work. An individual will not work if the wage is below the reservation wage. The individual
is indifferent between not working and working when the wage equals the reservation wage
(since the opportunity cost of leisure time is just equal to the wage at this point). Hence, an
individual‟s reservation wage is the minimum wage at which the individual chooses to
work; or, the maximum wage at which the individual chooses not to work.

Y U0 U1 U2 U3

Budget constraint
|slope| = real wage

|slope| = Reservation
Wage

0 T L
T
p 0 H

p p
p Wage, Zero Quantity of Labor
p Reservation Wage Greater Than Market
Figure 2.12:
Supplied

2.2 Non-Labor Income and Labor Supply

Up to this point, we have assumed that all income is received in the form of labor income.
Individuals, however, also receive income in the form of non-labor income. Income from
non-labor sources is referred to as "unearned income." This non-labor income may be

29
received in the form of interest payments, rent, dividends, profits, transfer payments, lottery
winnings, lawsuit settlements, or as any other income that does not vary with hours worked.
Using the definition: A = total amount of non-labor income, the time and goods constraints
that we derived above become:
 Time constraint: H + L = T
 Goods constraint: wH + A = pY

Note that the time constraint is the same as that discussed earlier (because you have a more
non-labor income, you do not have any additional hours in a day....). The goods constraint is
modified to account for two source of income: the earned income (wH) and the unearned
income (A).

Solving the first equation for H:

H=T–L
Substituting this for Y into the second equation results in:

w ( wT  A)
Y  ( ) L 
p p

w
An inspection of this budget constraint equation indicates that the slope equals  (as in
p
( wT  A)
the simpler model) and the intercept on the vertical axis equals .
p

Three budget constraints corresponding to alternative levels of non-labor income (A) appear
in the diagram below. As the level of non-labor income rises, the budget shifts vertically in
w
an upward direction. The slope remains constant at  .
p

Notice that the slope of the budget constraint stays the same when non-labor income
changes. While the budget constraint shifts upward as non-labor income rises, it still

30
terminates at T hours of leisure. No matter how wealthy you are, there are still only 24 hours
in your day. If leisure is a normal good, an increase in non-labor income results in an
increase in leisure time and a reduction in hours worked (as illustrated below).

wT+A1
p

wT+A0
p
wT
p

U2 A = A2

U1 A = A1
U0
A=0

0 T L
T 0 H

Figure 2.13: Non-Labor Income and Change in the Decision to Supply Labor

The change in hours worked that results from a change in real income, holding relative
prices constant, is called a "pure income effect." When leisure is a normal good, this income
effect reduces hours worked when income rises.

2.3 Income Replacement Programs and Labor Supply

2.3.1 Unemployment Compensation (or Full Disability Insurance)

If all lost income is replaced when the individual becomes unemployed, the individual
moves from point A to point B (in the figure below) if unemployed. Since point B lies above

31
the original indifference curve, however, this individual would receive a higher level of
utility if he or she were unemployed. This occurs because leisure time is valued by the
worker. For this reason, unemployment compensation systems do not generally provide
complete replacement of lost income.
To maintain the worker at the original level of utility, an appropriate level of compensation
would be equal to Y' in the diagram below. The problem, of course, is that Y' cannot be
determined by the government.

Figure 2.14: Unemployment Compensation (or Full Disability Insurance) and Labor
Supply

A similar argument can be applied to disability insurance programs. If disabled workers

receive the same level of income after an injury as before and receive more leisure time,
their level of utility would increase (assuming that "pain and suffering" and medical
expenses are fully compensated). Disability insurance programs require medical
examinations by approved physicians to reduce the possibility that workers will file
fraudulent disability claims.

32
2.3.2 Partial Disability

A work-related injury that results in a partial disability reduces the wage that the affected
worker will receive. This reduction in the wage generates both substitution and income
effects on the quantity of labor supplied. If the goal is to adequately compensate the worker,
however, an appropriate income replacement scheme would be to provide a payment that is
just large enough to offset the income effect resulting from the reduction in the wage (since
it is only the income effect that involves a loss in utility).

2.4 Welfare Programs and Labor Supply

 The government provides welfare benefits to those households in which the level of
income falls below the target level (Yt).
 Welfare benefits may take the form of monetary payments or subsidies for food,
housing, medical care, or other basic commodities.
 The goal is to provide a level of welfare benefits that brings the level of household
income up to the target level.
 If the individual does not work at all, the level of welfare benefits equals Yt.
 If the individual is working, but receives a level of income that falls below Yt, the
government provides enough welfare benefits to provide a total income of Yt.

33
 Figure 2.15: Welfare program and the Individual’s Budget Constraint

 The budget constraint is horizontal at an income level of Yt. In this portion of the
budget constraint, the marginal wage (the additional income resulting from an
additional hour of work) equals zero. If a welfare recipient works an additional hour
and receives a wage of $X, welfare benefits are reduced by $X, leaving total income
unchanged.

34
 Figure 2.16: Welfare Program and the Individual’s Labor Supply Decision

 An individual who, in the absence of a welfare system, has a level of income that lies
below the target level of income would always prefer to leave the labor force when
such a welfare system is available (since the level of income and leisure both
increase in this case). See the figure above.

35
 W

Figure 2.17: Even the Non-Eligible May Cease to Supply Labor

 Some individuals who, in the absence of this welfare system, would have received a
level of income that exceeds Yt, would also choose to leave the labor force. This
choice depends on whether the utility-maximizing indifference curve in the absence
of the welfare program passes below or above point W in the figure above.

To reduce the labor supply disincentive effects resulting from this type of welfare system,
 Welfare recipients are required to work a minimum number of hours to qualify for
welfare benefits. (Welfare benefits are zero unless welfare recipients work the
required minimum number of hours or are engaged in approved job training or
educational programs).
 Individuals are restricted to receiving welfare benefits for a limited number of years
(period).

36
Figure 2.18: Welfare program, Minimum Hours of Work and the Individual’s Budget
Constraint

 Individuals receive no benefits if they work for fewer than the minimum number of
hours (Hm, in this example).
 If they work for Hm or more hours, they receive the same level of benefits as under
the earlier system.

37
 Figure 2.19: Welfare program, Minimum Hours of Work and Labor Supply

2.5 A Standard Work Day and Labor Supply

Our discussion thus far has implicitly assumed that workers can individually determine the
number of hours they work. This is typically not the case. In practice, it is common to set
legal limitations for hours of work in many countries. E.g. in Ethiopia normal hours of work
are not greater than 8 hours a day or 48 hours a week (LP. No 42/1993. Art 61). The
imposition of such laws restricts the income-leisure choice of individuals. Some may find
this 8 hour work day a bit long and feel over employed, while other individuals in similar
circumstances find themselves under employed. To verify these possibilities, consider the
following conditions. For two persons A and B with their corresponding indifference curves,

38
 let HD be the standard work hours and each has either to work for HD hours a day or not at
all.

Consider the case of B. B‟s optimal position is at UB, where he prefers to work only for HhB
hours per day. But it is not a relevant choice. The relevant choice is between working the
standard work day at D or being non participant at N. In this instance, it is preferable to
work the standard work day because it entails a higher indifference curve IB2 as opposed to
IB1. At point D, Mr. B will feel over employed because at that level the worker values leisure
more highly at the margin than does the market. (At D, slope of IB2 is greater than the slope
of the budget line  MRSLY exceeds the wage rate).
Income

IA3
IA1

IA2

N‟

UA

UB

IB3
IB2

N
IB1

0
hA D hB H

Leisure Work

Figure 2.20: A Standard Work Day and Labor Supply

39
To overcome the feeling of over employment, workers engage in one of the following
actions:
 Absenteeism
 Reading journals or news at work deteriorating the quality of work.
 Leaving work before time
 Non punctuality at work

For person A, on the other hand, his optimal position is at UA where he prefers to work HhA
hours per day. But if the standard work day rule is applied, he would be located at E where
he will work only for HD hours per day. Being at E puts him on the lower indifference curve
IA2 than IA3 (his optimal choice) and at E, his personal valuation of leisure (the slope of the
indifference curve) is less than the market price (the slope of the budget line). Since this
person is limited to work only for HD hours instead of HhA hours, he would feel under
employed.

To overcome the feelings of under employment, workers can take one or more of the
following actions.
 Moonlighting (Taking two or more jobs)
 Extra hours of work (in the same place) = overtime work
 Part time work

2.6 Premium Wages and Straight Line Equivalents

Suppose that in a given industry a 10 hour workday (50-hour work week) becomes common
place. Does it make any difference with respect to work incentive to pay $ 4 per hour for the
first 8 hours of work and $6 per hour for an additional 2 hour over time or to pay 4.40 per
hour for each of the 10 hours of work? Since both payments yield the same daily income of
$ 44, one is inclined to conclude that it makes no difference. But, with the aid of the
following figure, we find that it does make a difference.

40
 P
I2

W‟ I3

U2

U3
W

U1
I1

O h2 h3 h1 H

Figure 2.21: Premium Wages and Straight Line Equivalents

The initial position is indicated by U1on I1 (a tangency position) and the individual is in
equilibrium earning an income of h1U1 and working for Hh1 hours.

Let us suppose that the employer offers additional hours of overtime work at premium pay.
Consequently, the relevant wage line becomes HU1P (not HU1W), and the new equilibrium
position is at U2 on the higher indifference curve I2. The introduction of premium pay for
over time work has resulted in an increase in labor supply, Hh2 > Hh1, for the employer and
improved welfare I2 > I1, for the worker.

Suppose instead of the standard work day pay rate and a premium pay for additional hours
worked, the worker is given the option of earning a straight time equivalent. Now, since the
straight time equivalent pay must yield the same income, (h2U2), to the worker for the same

41
hours worked (h2) as the wage line HU1P, the straight time equivalent wage line must pass
through U2, and is shown by HW‟.

However, his valuation of the opportunity cost of leisure at U2 (the slope of I2 at that point)
is greater than the market rate (given by the slope of the straight-time equivalent line). The
worker feels over employed when working Hh2 hours under the straight time scheme. If the
worker had his way with a straight time pay arrangement, he would work only Hh3 hours
(less than the required Hh2) and earn the lower income h3U3.

Premium pay for overtime work is a convenient arrangement for the employer since it
induces increased labor supply over and above what can be produced by the equivalent
straight time pay plan. Why the difference? The use of premium pay will have a relatively
small income effect because it applies only to hours worked in excess of Hh1, while a
straight time equivalent wage will have a much larger income effect because it applies to all
hours worked.

In general, premium wage rates for overtime work provide a greater incentive for additional
hours of work than a straight-time wage rate yielding an equivalent daily income.

Section Reflection

1. Describe how the supply of labor by an individual is derived from the constrained utility
maximization of the individual.
2. Discuss the impact of each of the following on an individual‟s decision to supply labor:
a. increase in non-labor income;
b. elimination of unemployment insurance;
c. abolition of a standard workday.

42
SECTION THREE: THE MARKET SUPPLY OF LABOR AND THE
ELASTICITY OF LABOR SUPPLY

Section Overview

SECTION THREE: THE MARKET SUPPLY OF LABOR AND THE

ELASTICITY OF LABOR SUPPLY

3.1 The Market Supply of Labor

3.2 The Elasticity of Labor Supply

3.1 The Market Supply of Labor

Market labor supply is the sum of the hours supplied by all the individual workers at each
wage rate. How does a wage change affect total hours of labor supplied to the market? First,
a rising wage brings more workers into the market (new entrants or job switchers), as the
wage is above the reservation wage for a larger number of workers. But second, a rising
wage has ambiguous effect on each worker‟s hours. Thus overall the effect is ambiguous.
That is, the labor supply curve does not necessarily slope up. Although there is a general
agreement that the supply curve of labor by single individuals exhibits the backward
bending pattern, it is usually the case that the market supply is not backward bending. This
is because higher wage rates, even if induce some people to work fewer hours, will also
attract new workers into the market and there is population growth due to births and
migration (in the long run).

Figure 2.22 below shows the possibility of simultaneously having backward-bending supply
of labor by individuals and an upward sloping market supply of labor.

43
 Figure 2.22: Backward Bending Individual Labor Supply Curves and an Upward
Sloping Market Supply of Labor

Two of the four individuals (A and B) in the figure above have backward-bending supply
curves. However, as the higher (rising) wage rate attracts new workers(C and D) to the
market, the total quantity supplied of labor continues to increase with wage rate.

What could causes of shifts in labor supply?

 Changes in wages for other (competing) jobs: Increase in other wages should
decrease supply to a labor market as workers see alternative jobs as more attractive.
 Changes in non-labor income: This decreases supply, as workers can afford to work
fewer hours, and some may even leave the labor force.

44
  Changes in tastes or social structure: for instance, values regarding the
appropriateness of married women working outside the home.
 Demographic shifts: Because labor supply varies with age and other characteristics,
market supply can shift as the composition of the population changes. For example, a
population with a growing percentage of very old people is likely to see its labor
supply decrease or grow less rapidly.

3.2 The Elasticity of Labor Supply

Economic theory predicts that the sign of the labor supply response to changes in the level
of unearned income (the income elasticity) is negative, but cannot be so definite as to the
likely effect on labor supply of a change in the marginal wage rate (the wage elasticity).

Theory predicts that the pure substitution effect (the effect of a change in the marginal wage
rate holding the level of utility constant) is positive. However, a change in the rate of income
taxation combines a substitution effect and an income effect which work in opposite
directions. Only by using empirical data on labor supply behavior can empirical researchers
quantify the magnitudes of income and substitution effects, and consequently evaluate the
sign and magnitude of the wage elasticities for different demographic groups.

Wage and income elasticities represent the standard criterion by which we judge the
characteristics of the labor supply function. The (uncompensated) wage elasticity of labor
supply,  ws , is defined as the proportionate change in the quantity of labor supplied divided
by the proportionate change in the wage rate.

That is,
Percentage Change in the Quantity of Labor Supplied
 ws 
Percentage Change in Wage rate

45
For example, a wage elasticity of 0.2 means that a 10% rise in the wage rate will result in a
2% increase in quantity of labor supplied.

Note that:
1. the uncompensated wage elasticity can be positive or negative
2. the uncompensated wage elasticity is not necessarily constant, either in magnitude or
in sign.

Over specific ranges of an individual‟s labor supply curve, the elasticity coefficient may be
zero (perfectly inelastic), infinite (perfectly elastic), less than one in absolute (inelastic),
greater than one (elastic), or negative (backward bending). The elasticity depends on the
relative strengths of the income and substitution effects generated by a wage rate change.

The income elasticity  Ys represents the proportional change in labor supply in response to a
proportional change in non-labor income.

Percentage Change in Labor Supply

 Ys 
Percentage Change in Non - labor Income

If  Ys < 0 if leisure is a normal good.

Section Reflection

1. Discuss how the market supply of labor is derived from the supply of labor by
individuals.
2. What factors affect the market supply of labor?
3. Interpret  ws  0.3 . How do you relate this to the relative strength of substitution and
income effects?

46
Unit Summary

1. Manpower contains the essential elements of labor supply such as education, skill,
training, experience, etc and hence it is the best approximation of labor supply.
However, because of the difficulty in measuring job efforts and productiveness (which
are unobservable), the labor force is the one commonly used. The estimates provided by
the approach commonly adopted (the labor force approach), like the concept and
measurement of labor supply, cause many problems.

2. Activity rate measures the extent of involvement in economic activities, or the level of
participation in the production and/or distribution of economic goods and services.
Participation rates differ from society to society or for different segments within a
society. The factors which contribute to such differences in activity rates include:
gender (male vs. female participation rates), culture, level of development. The most
powerful are the individual‟s job attachment and the business cycle.

3. According to the neoclassical model, an individual attempts to achieve the highest

possible level of utility. The choice among alternative levels of income and leisure,
however, is restricted due to two constraints: a time constraint, and a goods constraint.
The optimal combination of leisure and income occurs at a point of tangency between
the budget constraint and an indifference curve. A change in the wage results in two
effects on an individual's labor supply: a substitution effect, and an income effect. If the
real wage in the labor market is less than an individual‟s reservation wage, the
individual chooses to remain out of the labor force and a corner solution occurs.

4. Individuals‟ decision to supply labor is affected by factors like income replacement

programs (unemployment compensation, disability insurance …), non-labor income and
labor supply, welfare programs, a standard work day, and arrangements for overtime
work.

47
5. Although there is a general agreement that the supply curve of labor by single
individuals exhibits the backward bending pattern, it is usually the case that the market
supply is not backward bending.

6. Economic theory predicts that the sign of the labor supply response to changes in the
level of unearned income (the income elasticity) is negative, but cannot be so definite as
to the likely effect on labor supply of a change in the marginal wage rate (the wage
elasticity).

Review Questions

I. For Each of the Following Questions, Choose the Correct Answer

1. Knowing about substitution and income effects, one can predict that:
A. winning the lottery will decrease the winners labor supply.
B. an increase in the wage rate will increase the labor supply.
C. an increase in the wage rate will decrease the labor supply.
D. winning the lottery will have an ambiguous effect on the winner‟s labor supply.
2. For someone who does not work, except in a borderline case, the marginal value of an
hour of leisure is:
A. equal to the wage rate.
B. less than the wage rate.
C. greater than the wage rate.
D. negative.
3. The individual labor supply curve slopes upward if:
A. the income effect is negative.
B. the substitution effect is larger in magnitude than the income effect.
C. the substitution effect is positive.
D. the income effect is larger in magnitude than the substitution effect.

48
4. A time constraint represents:
A. all of the feasible allocations of time between leisure and work.
B. all the allocations of time between leisure and work for which the individual is
indifferent.
C. all of the optimal allocations of time between leisure and work
D. none of the above
5. The slope of an individual's income-leisure budget constraint is:
A. 24 hours minus the number of leisure hours.
B. the negative of the real wage rate.
C. total real income divided by the wage rate.
D. the real wage rate.
6. The (own) wage elasticity of labor supply:
A. is always positive
B. is always negative
C. is always zero
D. may assume different signs along a supply curve
E. None of the above is true.

II. For Each of the Following Questions, Write True If the Statement Is
Correct and False If the Statement Is Wrong.

7. A premium wage arrangement for overtime work generally provides a greater incentive
for work than a straight-time wage arrangement yielding the same daily income.
8. A standard workday might result in a sub-optimal allocation of time between work and
leisure for an individual.
9. In the classical theory of labor supply, the marginal rate of substitution between leisure
and income (MRSLY) increases as an individual has more leisure and less income.
10. Ceteris paribus, a less generous unemployment benefit entails a lower unemployment
rate as lower unemployment benefit decreases reservation wages and thereby raises job-
finding rate.

49
 UNIT THREE
THE DEMAND FOR LABOR

Unit Introduction

The demand for labor by a firm shows the quantities of the input that the firm would hire at
various alternative input prices (wage rates). In the short run, it is assumed that labor is the
only variable input (i.e., the amount used of the other inputs is fixed and cannot be changed).
In the long run, labor is combined with variable factors. Regardless of the time perspective,
the marginal concept dictates us that a profit-maximizing firm will continue to hire labor as
long as the extra income (receipt) from the sale of the output produced by the input is larger
than the extra cost of hiring the input.

The equality of the marginal benefit and marginal expense defines the optimal point of
operation in all kinds of market. However, the concepts of marginal benefit and marginal
expense entail different things to firms in different market structures. This fact gives rise to
different demand for labor functions for different types of firms. In this unit, we will derive
the demand for labor functions by firms under different market structures.

Unit Objectives

After studying the material in this unit, you are expected to:
 be able to derive both the short and the long run demand for labor by firms under
different market structures;
 understand how the market demand for labor is derived, again under different market
structures, the factors that determine the demand for labor;
 comprehend and apply the concept of elasticity of labor demand; and
 discuss the degree of substitutability between labor and other factors of production
(we will use capital for illustration) and relate this to the income share of factors.

50
SECTION ONE: THE DEMAND OF A FIRM FOR LABOR IN THE
SHORT RUN

Section Overview

SECTION ONE: THE DEMAND OF A FIRM FOR LABOR IN THE

SHORT RUN
)
1.1 Perfect Competition in Both the Product and
Labor Markets

1.2 Monopolistic Power in the Product Market

1.1 Perfect Competition in Both the Product and Labor Markets

The extra income that a firm gets from the sale of the output produced by labor is given by
the marginal (physical) product of the input (MPPL) times the marginal revenue of the firm
that level of production (MR). This extra income is called the marginal revenue product of
labor (MRPL). That is,

MRPL  MPPL  MR

When the firm is a perfect competitor in the product market, it is a price-taker and thus its
marginal revenue is equal to the commodity price. In this case, consequently, the marginal
revenue product of labor (MRPL) equals the value of marginal product of labor
( VMPL  MPPL  P ).

The extra cost of hiring an input or the marginal expenditure (ME) is equal to the price of
the input (wage rate = w) if the firm is a perfect competitor in the labor market. Perfect

51
competition in the labor market means that the firm demanding the input is too small, by
itself, to affect the price of the input. In other words, each firm can hire any amount of the
input (labor services) at the given market wage rate. Thus, the firm faces a horizontal or
infinitely elastic supply curve for the input. This means that the firm can hire any quantity of
labor time at the given wage rate.

Thus, a profit-maximizing firm should hire an additional unit of labor as long as the MRPL
exceeds the marginal expenditure on labor or wage rate (w). Profit is maximized at a point
where MRPL (= VMPL in this case) = MEL (= w in this case).

Mathematically, max  = R – C where R = PX. X and C = w L + F; F = fixed cost.

L

d d ( P X . X  w. L  F) dX dL
 = = PX - w = 0.
dL dL dL dL

 P X . MPPL = w .

 VMPL = w .

From your microeconomics, you may recall that a rational firm operates in the second stage
of production where the MPPL is declining but positive. Multiplying this, declining but
positive, MPPL by a fixed output price gives a downward sloping MRPL curve as in Figure
3.1 below.

52
 Figure 3.1: Equilibrium of a Firm in Perfectly Competitive Product and Labor Markets

Given this MRPL and the equilibrium condition MRPL = VMPL = w, the firm hires L1 units
of labor if the wage rate is w1. Similarly, L2 units of labor will be hired at w2 and L3 at w3.

At e1, VMPL = w1.  The firm‟s profit is at the maximum for wage rate w1. To the left of e1,
VMPL > w1.  The firm would increase its profit by hiring more labor. The opposite holds
to the right of e1. That is, the firm would increase its profit by reducing the amount of labor
it uses.

The graph that shows this relationship between the wage rate and the quantity demanded
(hired) of labor is the demand curve (Figure 3.2). Thus, the demand for labor is the value of
marginal product of labor (VMPL) under the perfectly competitive markets.

53
 3.2: The Demand of a Firm for Labor

1.2 Monopolistic Power in the Product Market

Assumptions:

1. The firm uses a single variable factor – labor – whose market is perfect: the wage rate is
given and the supply of labor to the individual firm is perfectly elastic.
2. The firm has monopolistic power in the output market. This implies that the demand for
the product of the firm is down–ward sloping and the marginal revenue curve lies below
the demand curve (MR < P) at all levels of output.
MRX < PX

 MRX . MPPL < PX. MPPL

 MRPL < VMPL

54
 Figure 3.3: MRPL  VMPL under Imperfectly Competitive Product Market

The firm maximizes its profit with respect to the units of labor it employs. Given demand
function PX = f1 (Q) and production function QX = f2 (L, K ),

 = TR – TC

  = PX .QX – ( w . L+F)

d d(TR) d(TC) d(PX Q X ) d( w.L  F)

max : F.O.C. = 0.     =0
L dL dL dL dL dL

 MRPL – w = 0

 MRPL = w

55
 d 2
S.O.C.  0.
dL2

So the firm maximizes its profit when it employs labor in such a way that MRPL = w (i.e., l1e
units of labor at wage rate w1, l2e at w2, and l3e at w3 in the figure below).

Figure 3.4: Equilibrium of a Firm and the Demand of the Firm for Labor

Joining the equilibrium points e1, e2 and e3 (at different wage rates) gives MRPL as a
demand curve that relates wage rate to labor employment.

56
 Section Reflection

1. What is the main difference between a perfect competitor and a firm with monopoly
power with regard to their employment decision?
2. What is the implication of this difference for the short run demand for labor function?

SECTION TWO: THE DEMAND OF A FIRM FOR LABOR IN THE

LONG RUN

Now, we are a point to derive the long run demand for labor by a firm, and then the market
demand for labor first under perfect competition and next under imperfectly competitive
markets.

Section Overview

SECTION TWO: THE DEMAND OF A FIRM FOR LABOR IN THE

LONG RUN
THE THEORY OF INDIVIDUAL LABOR SUPPLY
2.1 Perfect Competition in Both the Product and Labor
Markets

2.2 Monopolistic Power in the Product Market

2.1 Perfect Competition in Both the Product and Labor Markets

In the long run, when there are more than one variable factors of production, the VMPL is
not the demand for labor. This is because various resources are used simultaneously in the
production process so that a change in the price of labor (wage rate) leads to changes in the

57
employment (use) of the other factors. This in turn shifts the marginal (physical) product
curve of labor (whose price is initially changed).

Let‟s assume that the price of labor (the wage rate) falls. Then this has three effects: a
substitution effect, an output effect, and a profit-maximizing effect.

Initially, the firm produces a profit – maximizing output X0 with a combination of L0 and
K0, given factor prices w and r whose ratios are defined by the slope of the isocost line BC0
(Figure 3.5). When wage rate falls, the isocost BC0 changes to BC2 and this new isocost
(BC2) is tangent to the isoquant corresponding to output level X1 at e2. K2 units of capital
and L2 units of labor are used.

Figure 3.5: Substitution, Output and Profit Effects of a Fall in Wage Rate

This movement from e0 to e2 can be split into two: substitution effect and output effect. To
see the substitution effect, we draw an isocost line (B1C1) parallel to the new isocost line
(BC2) but tangent the old isoquant (X0). The movement from e0 to e1 is the substitution
effect. This shows that the firm substitutes the cheaper labor for the relatively more

58
expensive capital even if it were to produce the original level of output (X0). Thus, the
employment of labor will rise from L0 to L1.

But when wage rate falls, the firm can hire more of the two factors (L and K) with the same
expenditure. Hence, the firm produces higher level of output with more labor and capital (L2
and K2) and, therefore, the movement from e1 to e2 is the output effect.

Point e2 is not the final equilibrium of the firm because keeping the total cost/expenditure
constant doesn‟t maximize its profit. The fall in wage rate results in a shift in the marginal
cost curve downward to the right (from MC1 to MC2 in Figure 3.6 below) and the profit
maximizing output of the firm increases from X' to X".

P MC1
MC MC2

X
X' X"

Figure 3.6: Fall in Wage Rate Reduces the Marginal Cost of Production of a Firm

Thus, the isocost line BC2 (in Figure 3.5) must shift upward parallel to itself. So, the final
equilibrium is when isocost B3C3 is tangent to the highest possible isoquant (X2) at point e3.
The movement from e2 to e3 is the profit effect (or the profit-maximizing effect).

The substitution effect of a decline in wage rate causes a decline in the marginal physical
product of labor (as it increases the units of L and reduces that of K). The output and profit

59
effects result in rise in the amounts of both labor and capital used. Both effects cause the
MPPL to shift upward and to the right (increase the MPPL at a given level of employment).

The output and profit effects more than offset the substitution effect so that the final result of
a fall in wage rate is an increase (and rightward shift of) the MPPL (curve). Given the price
of the final commodity PX, the VMPL also shifts to the right as depicted in Figure 3.7 below.

Figure 3.7: Shifts in VMPL Curve, Equilibrium of a Firm and Labor Demand

At the initial wage rate w1, L1 units of labor are employed (which is determined by the
intersection of VMPL1 and the supply w1). The new equilibrium demand for L (when wage
rate falls to w2) is at point B on VMPL2. If w further declines to w3, the new equilibrium will
be at point C. The locus of points A, B and C is the demand curve for labor by the firm
when several variable factors are used. This is the long run demand for labor by a firm

60
because all the factors used (assumed to be only labor and capital here for simplicity) are
variable.

In this case, the demand for labor is not the same as its VMP curve, but derived from
changing (shifting) VMP curves.

2.2 Monopolistic Power in the Product Market

With monopolistic power in the product market and more than one variable factor in the
production process, the demand for labor is not MRPL curve, but it is formed from points of
shifting MRPL curves. Consider Figure 3.8 below.

Figure 3.8: Demand of the Firm for Labor

61
When the wage rate is w1, the equilibrium is at point A. If wage rate falls from w1 to w2, the
firm moves from A to A‟ along MRPL1 if every thing remains constant. However, other
things do not remain constant. The fall in wage rate has substitution, output and profit
effects. The net result of these effects is a shift in MRPL curve to the right which leads to
equilibrium at B. So, line AB is the demand for labor in this case.

Section Reflection

1. Discuss the difference between the short run and the long run labor demand curves of
perfect competitor.
2. What is the difference between the long run labor demand curve of a perfect competitor
and that of a firm with monopoly power?

SECTION THREE: THE MARKET DEMAND FOR LABOR AND

ELASTICITIES OF LABOR DEMAND

Section Overview

SECTION THREE: THE MARKET DEMAND FOR LABOR AND

ELASTICITIES OF LABOR DEMAND
ECTION TWO: THE THEORY OF INDIVIDUAL LABOR SUPPLY
3.1 The Market Demand for Labor

3.2 The Elasticity of Labor Demand

3.3 Elasticity of Factor Substitution

62
3.1 The Market Demand for Labor

The market demand curve for labor is derived from the individual firms‟ demand curves for
the input. But it is not the simple horizontal summation of the individual firms‟ demand
curves. This is because when the price of labor falls, not only this firm but also other firms
will employ more of this factor and other (complementary) inputs to expand production.
Thus, the supply of the final commodity increases and its price falls (See Figure 3.9).

Figure 3.9: The Effect of a Fall in Input Price on Commodity Price

If the wage rate falls and more of it is used, the supply of the commodity increases (shifts
from SX1 to SX2). This derives down the equilibrium price of the product from PX* to PX**.
This in turn has a negative consequence on the demand for labor.

63
Under perfectly competitive product and labor markets, since the MRPL = MPL times MR
(which is equal to the commodity price), the reduction in commodity price will cause each
firm‟s MRPL and demand curves for the input to shift down or to the left. The market
demand curve for labor is then derived by the horizontal summation of the individual firms‟
demand curves for the input after the effect of reduction in the commodity price has been
considered [See Figure 3.10 below].

(a) Firm’s Demand Curve (b) Market Demand Curve

Figure 3.10: Deriving the Market Demand for Labor

If the fall in commodity price were not taken into account, it would lead to an
overestimation of the market demand for labor (which joins points A and B‟).

The only difference when the product market is imperfectly competitive is that the
individual demand curves are based on MRPL (and not on VMPL).

64
If each firm is a pure monopolist (the only seller for its product), then the price of the final
commodity is likely not to be affected, and in such cases the market demand curve is the
simple horizontal summation of individual demand curves.

In general, the demand for labor depends on:

 The price of the input – increase in wage rate reduces the quantity demanded of the
inputs services, and vice versa. This represents a movement along a given demand
curve.
 The marginal physical product of the factor – if the MPPL increases, more of it will
be demanded, and vice versa.
 The price of the output (commodity) – when the output the firm produces becomes
cheaper, the firm will cut its production and thus demands less of the input used. The
opposite happens when the commodity becomes more expensive.
 The amount of other factors which are combined with the factor
 The price of other factors – increase in prices of complementary inputs reduces the
amount of the complementary inputs to be used with a given amount of labor, and
thus reduces the productivity of (and demand for) labor.
 Technological progress – technological progress could increase or decrease the
demand for labor depending on whether it increases or decreases the MPPL.

3.2 The Elasticities of Labor Demand

The elasticity of labor demand is a measure of the sensitivity of labor demand to a change in
one of its determinants. Below, we will see two elasticities of labor demand: the own-wage
elasticity and the cross-wage elasticity.

65
3.2.1 Own-Wage Elasticity of Labor Demand

The own-wage elasticity of labor demand is a measure of how sensitive is the demand for a
particular category of labor to a change in the wage rate in that specific labor market. The
own-wage elasticity of labor demand is defined as:

percentage change in employment in market i

i i 
percentage change in wage in market i

The i subscripts in the definition just refer to the specific labor markets used in the
numerator and denominator of the expression above. It is expected that the elasticity of labor
demand will vary substantially across labor markets.

An inspection of the definition above should indicate that the own-wage elasticity of labor
demand will always be negative as a result of the negative slope of labor demand curves.

When labor demand is elastic (/ηii/ > 1), a 1% increase in the wage will cause employment
to fall by more than 1%. If labor demand is inelastic (/ηii/ < 1), a 1% wage increase will
cause employment to fall by less than 1%. Employment will fall by 1% when the wage rises
by 1% if labor demand is unit elastic (/ηii/ = 1).

The Hicks-Marshall laws of derived demand state that own-wage elasticity of labor demand
will be relatively high when:
1. the price elasticity of demand for the final product is relatively high,
2. it is relatively easy to substitute other factors for this category of labor,
3. the supply of other factors of production is relatively elastic, and
4. this category of labor accounts for a relatively large share of total costs.

66
The Price Elasticity of Demand for the Final Product

When the price elasticity of demand for the final product is relatively high, the increase in
the price of the product occurring (because of higher wages and the implied higher marginal
costs of production) results in a larger reduction in the quantity of output demanded. If
output falls by more, then the firm will reduce its employment of labor (and all other inputs)
by a larger amount. Therefore, a given change in the wage will result in a larger reduction in
the quantity of labor demanded when the price elasticity of demand for the final product is
relatively high. Since a wage change results in a larger reduction in employment when the
price elasticity of demand for the final product is relatively high, we can see that labor
demand is more elastic in this situation.

Ease of Substitutability of Other Factors

The own-wage elasticity of labor demand is relatively high when it is relatively easy to
replace labor with other factors of production. If it is relatively easy to substitute other
factors for this category of labor, a wage increase will result in a larger reduction in the
quantity of labor demanded.

Elasticity of the Supply of Other Factors of Production

When the wage rate rises, firms will attempt to substitute other factors for labor. As they do
so, the demand for these factors will increase. When the supply of capital is relatively
elastic, this increase in demand results in a relatively large increase in the use of capital and
a relatively small increase in the price of capital. When the supply of capital is relatively
inelastic, however, the increase in the demand for capital drives up the price of capital by a
relatively large amount but has a relatively small effect on the quantity of capital employed
by the firm. When this occurs, the increase in the price of capital limits the amount of
additional capital that will be used as a substitute for labor. Thus, when the supply of other
factors is relatively elastic, the substitution effect will be larger and labor use will fall by a

67
larger amount. Since labor use falls by a larger amount in response to a wage increase when
the supply of other factors is more elastic, own-wage elasticity will be relatively high.

The Share of Labor Costs in Total Costs

When labor costs are a larger share of total costs, a wage increase will have a greater effect
on the firm's costs and therefore a greater effect on the price of output. If output price rises
by more, the scale effect (output effect + profit effect) will be larger and the reduction in
labor use will be greater. Therefore, an increase in a given category of labor's share of total
costs will result in a higher own-wage elasticity of demand for this type of labor.

3.2.2 Cross-Wage (Cross-Price) Elasticity of Labor Demand

The cross-wage elasticity of labor demand (also known more generally as the cross-price
elasticity of demand) is a measure of the effect of the change in the price of one factor of
production on the demand for another factor of production. It is defined as:

percentage change in the quantity of resource i demanded

i j 
percentage change in the price of resource j

A positive cross-price elasticity of demand between two inputs indicates that the two inputs
are gross substitutes. This will occur only if the substitution effect outweighs the scale
effect. Two inputs are gross complements if the cross-price elasticity is negative. Negative
cross-price elasticity occurs when the scale effect is larger than the substitution effect.

3.3 Elasticity of Factor Substitution

As factor prices change, the firm will substitute a cheaper input for a more expensive one.
This profit maximizing behavior will result in a change of the K/L ratio, and hence, to a
change in the relative shares of the factors. The size of this effect depends on the

68
responsiveness of the change of the K/L ratio to the factor price changes. A measure of this
responsiveness is the elasticity of factor substitution (σ).

percentage changein the K / L ratio

σ=
percentage change in the MRTSL, K

d (K/L)
( K / L) d (K/L) MRTSL , K
= = .
d (M RTSL, K ) dMRTSL, K (K/L)
(M RTSL, K )

In perfect input markets, the firm is in equilibrium when it chooses the input combination at
which MRTSL, K = w/r.
d (K/L) ( w/r)
 σ =.
d ( w / r ) (K/L)

The sign of σ is always non – negative because the K/L ratio and w/r ratio move in the same

direction: (w/r) ↑  labor is more expensive.  Capital is substituted for labor.  (K/L)

↑.  σ is non–negative.
 σ = 1  unitary substitutability

 σ < 1  inelastic substitutability

 σ > 1  elastic substitutability

There is an important relationship between the values of σ and the distributive shares of
factors.

 If σ < 1, a given percentage change in w/r ratio results in a smaller percentage

change in K/L ratio, so that the relative share expression increases. Thus, if σ < 1,
an increase in w/r ratio increases the distributive share of labor.

 If σ >1, a given percentage change in w/r ratio results in a greater percentage

change in K/L ratio, so that the relative share of labor decreases.

69
  If σ =1, a given percentage change in w/r ratio results in an equal percentage
change in K/L ratio, so that the relative share of labor remains unchanged.

In general, a change in the w/r ratio will cause the share of labor (relative to that of capital):
1) to change in the same direction if σ <1

2) to change in the opposite direction if σ >1

The share of labor is not affected by a change in w/r ratio if σ =1.

Section Reflection

1. What special care is needed to derive the market labor demand curve from the
individual firms‟ demand curves?
2. Discuss the major determinants of the demand for labor.
3. Define the cross-price elasticity of labor demand and comment on the possible range of
values it could take.
4. Explain the factors affect the own-price elasticity of labor demand.
5. Explain how the elasticity of substitution between labor and capital is related to the
share of labor in the value of total output produced.

Unit Summary

1. According to the marginal concept, a profit-maximizing firm will continue to hire labor
as long as the extra income (receipt) from the sale of the output produced by the input
(MRPL) is larger than the extra cost of hiring the input (MEL on the input) and to the
point MRPL = MEL. This general rule can be modified based on the structure of the
factor and product markets. If the firm is a perfect competitor in the product market,
MRPL is equal to and can be substituted by the value of marginal product (VMPL).
Perfect competition in the input market allows us to substitute MEL by input price (the
wage rate).

70
2. The demand for labor is a derived demand – derived from the demand for the final
commodities that the input is used in producing. For a firm that is a perfect competitor
in the product market, its demand curve for labor is either the same as the VMPL (=
MRPL) curve (this is the case in the short run) or a curve derived from equilibrium
points on shifting MRPL curves (in the long run). In the latter case, substitution, output
and profit-maximizing effects of a change in wage rate take a central position in
deriving the demand for the input. For a firm with monopoly power, the analysis is
similar but we use MRPL and not VMPL.

3. The market demand for labor is found by summing the individual firms‟ demand for the
input, but the effect of change in wage rate on commodity price and its repercussion
should be considered. Determinants of demand for labor include the input‟s own price,
its marginal physical product (MPPL), the price of final commodities in whose
production the input is used, the amount and price of complementary and substitutable
inputs, and technological progress.

4. The own-wage elasticity of labor demand tells us the magnitude of the change in the
quantity of labor demanded that occurs when the wage rate changes. Since changes in
the wage affect the quantity of labor demanded through the substitution and scale
effects, anything that influences the magnitude of the own-wage elasticity of labor
demand must somehow affect the magnitude of either the substitution or the scale effect
(or both). The own-wage elasticity of labor demand will be relatively high when: the
price elasticity of demand for the final product is relatively high; it is relatively easy to
substitute other factors for this category of labor; the supply of other factors of
production is relatively elastic; and this category of labor accounts for a relatively large
share of total costs. We can define other elasticities of labor demand in a similar
manner.

5. For a given production function, the relative share of labor falls if its relative price (w/r
ratio) rises and if firms are very sensitive in substituting capital for labor, i.e., if there is

71
 elastic substitutability between the two factors (σ > 1). It rises with rise in w/r ratio if σ
< 1, and remains unchanged if σ = 1.

Review Questions

I. For Each of the Following Questions, Choose the Correct Answer

1. The demand for labor is a derived demand as it depends on:

A. the quality of the resource.
B. the supply of the resource.
C. the price of the resource.
D. the demand for the output it produces.
2. For two inputs used in production, if the scale effect dominates the substitution effect,
then the inputs:
A. are gross substitutes.
B. could be either gross complements or gross substitutes.
C. are gross complements.
D. cannot be used at the same time.
3. The wage bill and the wage rate are positively correlated whenever:
A. the demand for labor is wage-elastic.
B. the employer is a monopolist.
C. the demand for labor is wage-inelastic.
D. the employer sells in a perfectly competitive product market.
4. The demand for labor is more wage-elastic:
A. when labor cost is a higher fraction of the total cost.
B. for less skilled workers.
C. when product demand is more price-elastic.
D. when any of the above conditions holds.

72
5. The extra benefit or receipt from the sale of the output produced by one additional unit
of labor is:
A. Marginal revenue
B. Marginal physical product of the input
C. Marginal revenue product of the input
D. Value of marginal product of the input
E. Factor price
6. Assuming a firm using several variable factors, what happens to the marginal
productivity of labor for a fall in wage rate at a given level of employment if the firm
does not want to change the units of output it produces?
A. Rises
B. Remains constant
C. Falls
D. Any one of the three may happen
7. All but one of the following changes cause the demand for labor (curve) of a firm to
shift:
A. Changes in MPP of capital
B. Technological progress
C. Fall or rise in wage rate
D. The price of the final commodity in whose production the input is used
E. None
8. If the elasticity of substitution between labor and capital (which are used in production)
is greater than unity and wage rate to interest rate ratio increases, then:
A. the shares of both labor and capital increase.
B. the shares of both labor and capital decrease.
C. the share of labor increases but that of capital decreases.
D. the share of capital increases but that of labor decreases.
E. None of the above.

73
9. The XYZ Company is a monopolist for a new, patented food supplement. If the demand
for the product is P = 25 – 2Q, and the short-run production function is given by Q = 4L,
then the firm's demand for labor can be written as:
A. w = 100 – 4L.
B. w = 25 – 4L.
C. w = 100 – 64L.
D. w = 25 – 8L.
10. A perfectly competitive firm that hires labor from a perfectly competitive labor market
will hire labor until the marginal physical product of labor equals:
A. w (= nominal wage rate)
B. P (= output price)
C. w x P
D. w/P

II. Answer Each of the Following Questions

11. What effect does the price-elasticity of the supply of other factors of production have on
the own wage elasticity of demand for labor? Show the effects when the supply of other
factors of production is relatively elastic and relatively inelastic.
12. Why is MRPL curve not the demand for labor curve when there are several variable
factors of production? Explain!
13. Under perfectly competitive product and factor markets, the market demand curve for an
input is not the simple horizontal summation of the individual demand curves for the
input by individual firms. Do you agree? Argue for or against!

74
 UNIT FOUR
LABOR MARKET EQUILIBIRIUM

Unit Introduction

In many ways, the determination of wage and employment is similar to the pricing and
output determination of commodities. That is, the interaction between the market forces of
demand and supply generally determines the wage rate and employment of labor.

The pricing of any factor of production (input) takes place in various markets. We will first
examine the determination of wage rate in perfectly competitive product and labor markets.
Subsequently we will relax the assumption of perfect competition and discuss labor pricing
in markets with various degrees of imperfection. Finally, we will see the various theories of
wage determination and the wage payment systems practiced in the real world.

Unit Objectives

Hence, after thoroughly going through this unit, you students are expected to:
 Describe how the demand for and the supply of labor interact to determine the wage
rate and employment level under perfect and/or imperfect competitions in the output
and/or input markets;
 Explain the exploitation of labor because of the existence of monopolistic and/or
monopsonistic power (of firms);
 Understand the influences of institutional factors such as labor union and minimum
wage laws on the labor market.
 Distinguish among the various theories of wage determination and among the
various systems of wage payment.

75
SECTION ONE: WAGE DETERMINATION UNDER DIFFERENT
PRODUCT AND LABOR MARKETS

Section Overview

SECTION ONE: WAGE DETERMINATION UNDER DIFFERENT

PRODUCT AND LABOR MARKETS

1.1 Wage Determination under Perfectly

) Competitive Product and Labor Markets

1.2 Wage Determination and Monopolistic

Exploitation

1.3 Wage Determination and Monopsonistic

Exploitation

1.4 Bilateral Monopoly

1.5 A Labor Union Facing Perfectly

Competitive Firms

1.1 Wage Determination under Perfectly Competitive Product and Labor

Markets

In a perfectly competitive labor market, the labor supply curve facing each firm is
horizontal. There are so many buyers and sellers in a perfectly competitive market that each
buyer and seller is a "price-taker." In this case, each firm may hire as many or as few
workers as it wishes at the established market wage rate. But, what or who establishes the
market wage?

76
Given the market supply of and the market demand for labor (discussed in chapters 2 and 3,
respectively), now it is easy to determine the labor market equilibrium. This equilibrium is
determined by the intersection of the two curves.

Figure 4.1: Wage Determination

The equilibrium wage rate is w* and the employment level is L* (Figure 4.1). This is the
same as the determination of price for a commodity.

The difference between commodity pricing and labor pricing lies in the determinants of the
demand for labor and the method used to derive the supply of labor. Specifically,
1. Whereas consumers demand commodities because of the utility or satisfaction they
receive in consuming the commodities, firms demand labor in order to produce the
goods and services demanded by the society. That is, the demand for labor is a
„derived demand‟; it is derived from the demand for the final commodities that the

77
 input is used in producing. For instance, the demand for labor by a farmer is
explained by the demand for wheat or any other product.
2. While consumers demand commodities, firms demand the services of labor. That is,
firms demand the flow of labor services and not the stock of the labor itself.
3. Unlike the supply of commodities, the supply of labor is not determined by the cost
of production, but involves the attitudes of individuals toward work and leisure.

Shifts in Labor Market Equilibrium:

 An increase in labor demand results in an increase in both the equilibrium wage and
the equilibrium level of employment,
 A reduction in labor demand results in a decrease in both the equilibrium wage and
the equilibrium level of employment,
 An increase in labor supply results in a lower equilibrium wage, but a higher
equilibrium level of employment, and
 A reduction in labor supply results in a higher equilibrium wage, but a lower
equilibrium level of employment. [etc…]

1.2 Wage Determination and Monopolistic Exploitation

When firms have monopolistic power, labor is paid its MRP, which is smaller than the
VMPL. This effect is called monopolistic exploitation. It represents the difference between
the amount labor is paid under perfect competition and the amount the same factor (labor) is
paid under the imperfection introduced to the product market. If firms under the two
scenarios have to use the same amount of labor (L2 in panel (a) of Figure 4.2) the firm in
perfect competition pays a wage rate of w1 while the other firm pays w2. w1 - w2 measures
the level of monopolistic exploitation by the firm. The same concept is depicted in panel (b),
but at the market level.

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 Figure 4.2: Monopolistic Exploitation (a) at Firm’s Level, and (b) at the Market Level

1.3 Wage Determination and Monopsonistic Exploitation

Here we will examine the case of a firm that has monopolistic power in the product market
and monopsonistic power in the input market.

79
Assuming the only variable input to be labor, the demand for labor by an individual firm is
given by MRPL. However, the supply of labor to the individual firm is not perfectly elastic,
because the firm is large in this case.

Suppose that the firm is the only buyer of the input (a monopsonist). The supply of labor has
a positive slope: as the monopsonist expands the use of labor he/she must pay a higher
wage.

The supply of labor shows the average expenditure or price that the monopsonist must pay

at different levels of employment. Its slope is dw which is greater than zero ( dw > 0).
dL dL

Figure 4.3: The Demand, Supply, and Marginal Expenditure of Labor to a Monopsonist
when Labor is the Only Variable Factor

Multiplying the price of input by the level of employment gives the total expenditure of the
monopsonist for the input (TEL = w. L).
TEL = w. L

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  AEL = TE L = wL = w.
L L
 w = AEL = f (L)…………The supply of labor the monopsonist faces.

The relevant magnitude for the equilibrium of the monopsonist is the marginal expenditure
of purchasing an additional unit of the factor.

MEL = d (TEL ) =
d ( wL) dL + L dw
dL dL = w. dL dL

 MEL = w + L dw
dL

 Since dw > 0, L > 0 and w > 0, it follows that MEL > w for any level of
dL
employment (supply) – depicted in Figure 4.3 above.
 The MEL has also a steeper slope than the supply curve – w (SL). Assuming linear
functions,

 The slope of the supply function is dw > 0.

dL
 The slope of the MEL curve is:

d ( ME L ) =

d w  L dw
dL

dL dL

= dw +

d L dw
dL

dL dL
2
= dw + ( L.d w + dw . dL )
dL dL2 dL dL
2
= dw + dw + L.d w
dL dL dL2
2
= 2 dw + L.d w
dL dL2
2 2
 2 dw + L.d w > dw (since L.d w = 0 for a linear function).
dL dL2 dL dL2
(Slope of the MEL curve) > (Slope of the supply curve)

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The firm is in equilibrium when it equates the ME on labor to its MRP as shown in Figure
4.4 below.

Figure 4.4: Equilibrium of a Monopsonist Using a Single Variable Factor

Profit is maximized by employing Les units of labor for which MEL = MRPL. The wage rate
that the firm will pay for the Les units of labor is we – defined by the supply curve.

The wage rate and the employment of labor are lower than that of perfect competition as
well as that of monopoly market discussed earlier (in section 1.2). Look at the figure below.

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 Figure 4.5: Monopsonistic Exploitation

 wC = wage rate paid under perfectly competitive product and factor markets.
 wM = wage rate paid under perfectly competitive factor market and imperfectly
competitive product market.
 wS = wage rate paid under imperfectly competitive product and factor markets.

 wC > wM > wS (and LC > LM > LS)

 wC – wM is monopolistic exploitation
 wC – wS is monopsonistic exploitation (wC – wM due to monopolistic power in
the product market and wM – wS solely due to monopsonistic power in the factor
market).

1.4 Bilateral Monopoly

Bilateral monopoly arises when a single seller (monopolist) faces a single buyer
(monopsonist). In this model, we assume that all firms are organized in a single body that

83
acts like a monopsonist, while the labor is organized in a labor union that acts like a
monopolist (a model in which the participants are two monopolies, one on the supply side
and one on the demand side).

The solution to a bilateral monopoly situation is indeterminate. The model gives only the
upper and lower limits within which the wage rate will be determined by bargaining. The
outcome of the bargaining cannot be known with certainty. It will depend on bargaining
skills, political and economic power of the labor union and the firms, and on many other
factors.

The monopsonist‟s demand curve is Db, which is the MRPL. From the point of view of the
monopolist (labor union) this curve represents its average revenue curve (ARs). The seller‟s
(union‟s) marginal revenue, MRs, is derived from the ARs and lies below it.

Figure 4.6: Bilateral Monopoly

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The supply of labor facing the monopsonist is the upward sloping curve, SL. This shows the
average expense (average cost) of labor to the monopsonist. Corresponding to this average
cost curve is the marginal expenditure (MEL) curve. From the point of view of the
monopolist (labor union), the MCs may be considered its supply curve (assuming that it
behaves as if it were a perfectly competitive seller – it charges a single price for a given
level of labor service).

The monopsonist maximizes its profit at point F, where its marginal expense on labor (MEL)
is equal to the marginal revenue product of labor (MRPL). Thus, the monopsonist desires to
hire LF units of labor and to pay a wage rate equal to wF.

The monopolist (labor union), on the other hand, maximizes its gains (profits) at point U,
where its marginal cost (MCs) is equal to its marginal revenue (MRs). Thus, the monopolist
will want to supply LU units of labor and to receive a wage rate equal to wU.

The price desired by the monopsonist is the lower limit and the price desired by the
monopolist is the upper bound. The actual wage is between wF and wU, which is determined,
based on the bargaining skills (power) of the two parties. The stronger the monopolist, the
closer the actual wage rate is to wU; and the stronger is the monopsonist (the firms‟
organization), the closer the actual wage rate is to wF.

1.5 A Labor Union Facing Perfectly Competitive Firms

In this model it is assumed that the firm has neither a monopoly nor a monopsony power.
The labor force, however, is unionized and behaves like a monopolist in the labor market.
As in the case of bilateral monopoly, the supply curve shows the marginal cost of the labor
union. The market demand for labor DL is the aggregate VMPL curve, which is derived from
the summation of individual firms demand curves. The curve is also the AR for the labor
union (ARS), from which the marginal revenue (MRS) can be derived using the usual
method.

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Wage rate in the market depends only on the goals of the labor union. To understand how
the goals of the labor union determine wage rate in such a model we will examine the wage
rates that will prevail under the three most commonly pursued goals by unions.

W1 SL = MCL
W2

W3 E3

E1
DL = VMPL = ARS
E2
L1 L2 L3 L
MRS

Figure 4.7: Equilibria of a Labor Union Facing Perfectly Competitive Firms

GOAL 1: The maximization of the total gains/profit to the union as a whole. The
attainment of this goal requires the union to set wage rate at the level corresponding to the
equality of MCL and MRS. The equilibrium of the union is thus at point E1. The
corresponding wage rate and employment will be W1 and L1, respectively.

GOAL 2: The maximization of employment. The highest level of employment is defined by

the intersection of the demand for and the supply of labor. If this is the goal of the union,
then equilibrium will be attained at point E3. Hence, the firms being price-takers will
maximize profit by equating wage equal to VMPL. Therefore, total employment will be L3
and each worker will receive wage rate equal to W3.

GOAL 3: The maximization of the total wage bill. If the union aims at maximization of
wage receipts, then it seeks to set wage rate at the level in which the marginal revenue of the

86
union (MRS) is equal to zero. In this case, the equilibrium of the union is at point E2.
Therefore, the union will set wage rate equal to W2 and hence employment will be L2.

The moral of the story is that the wage rate and level of employment are determined by the
goal of the union if firms do not have no market power in both the product and factor
markets. However, it has to be noted that the effect of a rise in wage rate is a decline in the
level of employment. Members of the union who lost their jobs as a result of a rise in wage
rate are worse off, unless the total wage bill has increased and the union distributes it equally
to all members of the union (employed and unemployed).

Whether the total wage bill will increase following the rise in wage rate depends on the
elasticity of demand for labor. If the demand for labor is inelastic, the union‟s ability to
increase the total wage receipt by employed members will be effective. If the union
distributes these larger receipts to all union members, clearly the union‟s action is
beneficiary. However, if the demand for labor is elastic, not only the total employment but
also the total wage bill will decline and the union members as a whole will be worse off;
although the ones who do not lose their job will be better off because of the higher wage set
by the union. Therefore, it can be concluded that when the firms do not have market power,
the effects of the union‟s action may or may not be beneficiary to all of its members.

Section Reflection

1. Draw a graph of demand and supply to describe how a reduction in labor demand
affects the equilibrium wage rate and employment level.
2. Distinguish between monopolistic exploitation and monopsonistic exploitation.
3. What is the source of this difference?
4. Explain why the market wage is indeterminate in the situation of bilateral monopoly.

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SECTION TWO: LABOR UNION AND MINIMUM WAGE LAWS

Section Overview

SECTION TWO: LABOR UNION AND MINIMUM WAGE LAWS

2.1 Labor Unions and the Union Wage

) Advantage

2.2 Minimum Wage Laws

2.1 Labor Unions and the Union Wage Advantage

There are two major types of unions: industrial unions and trade unions (trade unions are
also known as craft unions). Industrial unions attempt to organize all of the workers in an
industry, regardless of the type of work that is done. Trade unions attempt to organize all of
the workers performing a particular type of job, regardless of the industry in which the
worker operates.

So, who represents certain professionals? Is it the industrial unions and trade unions? It turns
out that the workers themselves vote on who will represent them. In each unionized firm,
workers are organized into shops, groups of workers performing similar tasks. Each shop
votes on which union will serve as their bargaining agent for collective bargaining purposes.
Each shop is represented by only one union in negotiations with the employer.

Under a collective bargaining agreement, unions negotiate a wage with the employer. An
effective union negotiates a wage that is above the equilibrium wage. In the diagram below,
this is represented by a union negotiated wage of w'. As this diagram suggests, one of the
costs of receiving a higher wage is a reduction in the level of employment (from L* to L').

88
Note also that there are more people who wish to work at a wage of w' than there are jobs
available. This factor limits the ability of the union to negotiate higher wages.

Figure 4.8: Collective Bargaining Agreement and the Wage Rate

In some cases, however, unions are able to convince the government to pass laws that give
unions some control over labor supply. Since unions control the process of licensing, this
gives unions substantial ability to control labor supply in some industries. The diagram
below illustrates the effect of a labor supply restriction.

89
 Figure 4.9: Supply Restriction and the Wage Rate

As is the case with a collective bargaining agreement, a supply restriction results in a higher
wage (w') and a reduced level of employment (L'). The difference, though, is that there are
no unemployed workers in this market since the supply restriction prevents these additional
workers from ever appearing in this market.

Unions attempt to increase the incomes of their members. When labor demand is relatively
inelastic, a given wage increase will result in a smaller impact on employment. If labor
demand is relatively elastic, however, a wage increase results in a relatively large reduction
in employment. Clearly, unions would prefer to be operating in a labor market in which
labor demand is more inelastic. This results in a few interesting results concerning union
strategies:

90
  unions will be more successful in receiving wage increases in markets in which labor
demand is relatively inelastic,
 unions will attempt to reduce the own-wage elasticity of demand for their workers,
and
 unions might prefer to organize those labor markets in which labor demand is
relatively inelastic.

The following points are linked to the Marshal laws of derived demand (discussed in unit 3):
 Since labor demand is more inelastic when the demand for output is more inelastic,
labor unions will receive larger wage increases when labor demand is more inelastic.

 Unions consisting of skilled workers were historically the first successful unions.
One of the reasons for this is that skilled workers are harder to replace than unskilled
workers in many production processes. By reducing the ease of substitution among
workers, unions are able to reduce the own-wage elasticity of demand for each type
of worker. Unions generally favor restrictions on immigration and were active
supporters of mandatory education and child labor laws. One of the reasons for this
support is that immigrant workers and children serve as low-cost substitutes to union
workers. By reducing the availability of immigrant and child labor, unions are able to
face a more inelastic demand curve for labor.

 Unions advocate child labor laws and laws restricting immigration partly to limit the
supply of substitutes and also to reduce the elasticity of supply of substitute labor. By
raising the penalties associated with illegal immigration or with violations of child
labor laws, the supply of these other sources of labor is reduced, but also becomes
more inelastic (since a larger wage increase is required to induce a given increase in
the supply of illegal labor).

 Of course, it is unlikely that unions will actively attempt to reduce the share of labor
costs in total costs. Unions, however, have been relatively more effective historically

91
 in capital-intensive industries in which labor costs are a relatively small share of total
costs. One of the reasons for the limited success of unions in the service sector is that
labor costs are a relatively large share of total costs in this sector.

Measuring the Union Wage Advantage

The pure union wage advantage is the percentage by which the union wage (Wu) exceeds
the nonunion wage that would exist without the union (Wn).
Wu  Wn
A( )  100
Wn
where A is the pure union wage advantage, Wu is the union wage and Wn is the nonunion
wage.

Ideally, the union wage advantage should be determined under “laboratory conditions” in
which we compare union and nonunion wages with all other possible influences on wages
being constant. The problem, of course, is that there is no way of conducting such a
controlled experiment. In particular, it is impossible to observe what the earnings of
unionized workers would be in a given labor market if the union did not exist. The best that
can be done is to compare the wages of workers of a specific kind in unionized (or strongly
unionized) markets with the wages of workers in the nonunion (weakly unionized) markets.

A basic conceptual problem in measuring the pure union-nonunion differential arises

because:
 Unionization may affect wage rates in nonunion labor markets, pushing them upward
or downward and creating a bias in the measurement of the union wage advantage.
Furthermore, the potential influence of unions on nonunion wages can take several
different forms, so that the overall impact is ambiguous.
 Union wage setting may influence the quality of the unionized workforce.

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The measured union wage advantage may overstate or understate the pure advantage
depending on which of the following effects are dominant.

1. The Spillover Effect – refers to the decline in nonunion wages that results from
displaced union workers supplying their services in nonunion labor markets. Because
the spillover effect depresses observed nonunion wages, the measured union wage
advantage is larger than the pure wage advantage – causing the union wage
advantage to be overstated. However, some economists argue that displaced union
workers may not supply labor in the nonunion markets but remain in the unionized
labor markets hoping to be recalled to their higher-paying jobs (wait unemployment).
This wait unemployment could be encouraged by the availability of unemployment
insurance. If wait unemployment occurs, the measured union wage advantage more
accurately portrays the pure wage advantage.

2. The Threat Effect – refers to an increase in nonunion wages that a nonunion

employer offers as a response to the threat of unionization. This is because nonunion
employers will feel increasingly threatened with unionization when workers in union
firms obtain wage increases. If the threat effect causes union wage increases to pull
up nonunion wages, then the measured union wage advantage will understate the
pure union advantage.

3. The Product Market Effect – a union pay increase, through its effect on costs and
prices, shifts demand to firms in the non-union sector. The added demand for
nonunion output is translated into added demand for nonunion labor, which could
have a pay-raising influence. Argued this way, the product market effect causes the
measured wage effect to understate the pure advantage.

4. The Superior-Worker Effect – the higher wages paid by union firms will cause
workers to queue up for these “good” union jobs. Given the availability of many job
seekers, unionized employers will carefully screen these prospective workers for

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 those having the greatest ability, the most motivation, the least need for costly
supervision, and other worker traits contributing to high productivity. This means
that, in time, high-wage union firms may acquire superior workforces in comparison
to nonunion firms. To the extent that “superior workers” acquire the high-wage
union jobs, the measured union advantage would overstate the union wage
advantage. Part of the higher wages paid to such workers is attributable to their
higher productivity rather than to the presence of the union as an institution.

If the spillover and superior-worker effects are dominant, the measured union wage
advantage will overstate the pure advantage; if the threat and product-market effects are
dominant, the measured union wage advantage will understate the pure advantage.

2.2 Minimum Wage Laws

One factor that should be kept in mind when analyzing the minimum wage is that the
minimum wage is specified in nominal terms, not real terms. Once a new higher minimum
wage is passed, its real value begins to decline as a result of inflation. Most of the increases
in the minimum wage over time have been designed to restore the real minimum to its past
higher real values.

The introduction of a minimum wage law that covers all employees into a perfectly
competitive labor market will be expected to result in a reduction in employment.

Let's examine what happens in perfectly competitive labor markets when some workers are
not covered by the minimum wage law. The diagram below illustrates the effect of having a
"non-covered" sector of the economy.

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 THE COVERED SECTOR
THE NON-COVERED SECTOR

Figure 4.10: A Minimum Wage Law and the Covered versus the Non-covered Sectors

In the absence of a minimum wage law, the equilibrium wage would equal Wo in both
sectors of this market. The introduction of a minimum wage in covered firms result in an
increase in the wage (to Wm) and a reduction in employment in the covered sector of the
economy. Workers who cannot find work in the covered sector have the option of shifting to
firms that are not covered by the minimum wage law. This will result in an increase in
supply in the non-covered sector. In response to this increase in supply, employment in the
non-covered sector will increase, but wages in this sector will decline.

Notice that an increase in the minimum wage need not result in increased employment as
long as the workers who lose their jobs in the covered sector are able to shift to work in non-
covered firms. Despite this, however, there is still an efficiency cost for society since the
marginal revenue product of the last worker hired in the covered sector will exceed the

95
marginal revenue product of the last worker hired in the non-covered sector. Society would
have been able to produce more total output if the MRP were the same in both sectors.

An example might help to illustrate this efficiency cost. Suppose that the minimum wage is
$5.10 and the wage in the non-covered sector is $4.50. The loss of one hour of labor in the
non-covered sector results in a loss of $4.50 in output in this sector. If this hour was
transferred to the covered sector, nearly $5.10 in additional output can be produced,
resulting in a net gain to society of $.60 an hour.

The analysis that was applied above to the effect of a minimum wage can also be used to
explain the effects resulting from the introduction of an industrial union into some, but not
all, of the firms in an industry.

In general, the theories that we have discussed suggest that a minimum wage law (or union)
will result in:
 unemployment and economic inefficiency if the labor market is perfectly
competitive and there is complete coverage, and
 economic inefficiency if the labor market is perfectly competitive and there is a non-
covered sector.

Section Reflection

1. What types of labor union do you know? How do they differ?

2. How does a labor union influence the market wage rate? What factors are likely to
constrain its power to do so?
3. Why is it difficult to measure the union wage advantage?
4. Discuss the possible impacts a minimum wage law on the economy.

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SECTION THREE: WAGE THEORIES AND WAGE PAYMENT
SYSTEMS

Section Overview

SECTION THREE: WAGE THEORIES AND WAGE PAYMENT

SYSTEMS

3.1 Theories of Wage

3.2 Wage Payment Systems

3.1 Theories of wage

Wages, payment received by an employee in exchange for labor. It may be in goods or

services but is customarily in money. The term in a broad sense refers to what is received in
any way for labor, but wages usually refer to payments to workers who are paid by the hour,
in contrast to a salary, which implies a more fixed and permanent form of income (e.g.,
payment by the month rather than by the hour). In economic theory, wages reckoned in
money are called nominal wages, as distinguished from real wages, i.e., the amount of goods
and services that the money will buy. Real wages depend on the price level, as well as on the
nominal or money wages.

Many theories have been advanced to explain the nature of wages. The first of them was the
subsistence theory of wages, also called the “iron law of wages,” of which
David Ricardo was one of the main exponents. The theory maintains that wages cluster
around the bare subsistence level of workers. A wage rate much above the subsistence level
causes an increase in the number of workers; competition will then lead to a depression of
wages back toward the cost of subsistence. Wages that are below subsistence reduce the size

97
of the working population; in that case competition will raise wages, but only up to the
subsistence level again.

Criticisms on subsistence theory of wages include the following:

 The subsistence level is uniform for all working labor with certain exceptions. The
theory thus does not explain differences of wages in different employments.
 The fundamental weakness of subsistence theory lies in its long term character. It
contains adjustment of wages over lifetime of a generation and does not explain
wage fluctuations from year to year.
 "The subsistence minimum" varies and is vague. Does it refer to the minimum
requirements of a modern man or of a tribal savage? There is not rapidly fixed
minimum and it is not independent of the wages ruling over a period of time.

In the surplus-value theory as propounded by Karl Marx, the value produced by the worker
in excess of what is paid in wages is called surplus value. The surplus value, exacted from
the worker, constitutes the capitalist's profit. The wage-fund theory is that wages are
advanced out of a fixed fund of capital, from which an excess withdrawal, either through
legislation or through union pressure, will ultimately reduce the amount available for other
workers. Any increase in wages would also have to be taken out of profits, and their
reduction would cause a decline in savings, which provide the capital from which the wage
fund is derived.

The residual claimant theory has been propounded by the American economist, Walker.
According to him, "Wages are the residue left over, after the other factor of production has
been paid". According to Jevon's words, "The wages of a working man are ultimately
coincident with what he produces, after the deduction of rent, taxes and the interest on
capital." Therefore, the remainder of the total output goes to the workers as wages after rent,
interest and profit have been paid. The efficiency of laborers has important role to increase
wages due to increase in production.

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This theory has been criticized on the following grounds:
 Role of Trade Unions: This theory ignored the important role of trade unions in
determining the wages.
 Ignorance of Supply side: This theory is also ignored the influence of supply of labor
on wages.
 Remuneration of other Factors: The other factors are land, capital and entrepreneur.
The same laws of demand and supply to explain the remuneration of the above other
factors of production cannot be applied to wages as well.
 Entrepreneur is the Residual claimant: The entrepreneur under takes to pay the other
factors of production before he can expect to get anything. Therefore, it is the
entrepreneur who is the residual claimant but not the worker.

The marginal-productivity theory maintains that employers will only pay a wage that is, at
most, equal to the amount of extra value added to the total product by one additional worker.
We have been using this theory throughout our previous discussion. The bargaining theory
modifies the marginal-productivity theory by taking into consideration other factors (e.g.,
laws and social and political changes) that might affect the determination of wage levels and
by acknowledging that certain basic assumptions (equal bargaining power of employer and
employee, free competition between the two, and mobility of labor) that characterize the
marginal-productivity theory do not hold in our present economic system.

3.2 Wage payment systems

The compensation to an employee may be in three forms:

 based on time spent on work, i.e., time rate system,
 based on production in quantity terms, i.e., piece-rate system, and
 combination of (i) and (ii) both, i.e., wage-incentive system.

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3.2.1 The Piece Rate Systems

Wages are paid in this system in accordance with the output of production. This is
independent of time spent on the job. For example, if a worker produces 325 pieces per day
and he is paid at the rate of Birr 0.20 per piece, the daily wage income is 325×0.20 = Birr
65. The rate is normally developed on the basis of the analysis of the previous system
performance and establishment of average performance of a particular standard of
workmanship.

Some of the advantages of the straight piece rate wage payment system are:
 It stimulates effort in an expectation of higher wage
 The more efficient worker gets higher rewards.
 It eliminates regular supervision of workers
 It adds interest to routine work.
 It develops team sprit when workers operate in small group.
 It encourages workers to suggest methods that would improve production.

The disadvantages of straight piece rate wage payment system include:

 In his/her effort to produce more, the worker may disregard the spoilage of tools or
machineries used for production.
 If a worker is paid merely on the basis of the number or quantities of items produced
the quality of goods produced (products) is likely to decline. This is therefore, a
tendency to scarify quality for quantity.
 Ones a worker has earned enough through this method, he/she is inclined to remain
absent or take holiday because of his/her savings.
 The worker may overexert himself as he tries to work his maximum speed to earn
more income.
 No compensation for sickness.
 No guarantee of minimum wage.

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Thus, this system is suitable in cases of:
 Repetitive jobs having no innovation.
 Jobs where individual contribution may be measured.
 Skilled workers in small firms.
 When the quantity of production/output is the focus.

Sometimes, the straight piece rate method is modified to guarantee a minimum wage to
yield the straight piece rate with a minimum guaranteed base wage. In this method, in
addition to the payment in accordance with an individual‟s output, a fixed guaranteed base-
wage is also provided. However, for a production up to a certain level there is no incentive.
For example, suppose that the standard output in a hypothetical welding shop is 110 pieces
per day. For a production less than or up to the standard output, the minimum guaranteed
daily wage is Birr 70. Over the standard output an incentive at the rate of Birr 0.25 per piece
is given. If an individual produces 150 pieces in a day, his daily wage income will be: 70 +
0.25 x (150 – 110) = Birr 80. This is an example of minimum guaranteed base-wage system.

Still another variant of the piece rate exists in practice: the differential piece rate system (or
Taylor’s plan). In this scheme, up to a certain production level, which may be standard
output, a piece rate (say R1) is given. Anybody who achieves more than this output level,
will get the payment for over achievement at a higher rate (say R2). However, it does not
guarantee minimum base wage. Standard output may be decided by careful time and unction
study procedure.

Advantages of differential piece rate system:

 It provides incentives to efficient worker.
 It penalizes inefficient worker.
 It focuses on high production rate.
 It is simple and easy to implement.

Disadvantages of differential piece rate system:

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  Minimum wage is not assured.
 No consideration for the machine failure, power failure, etc.
 Over emphasis on high production rate; there are chances that quality of work may
suffer.

All the three approaches of piece-rate system are compared in the following figure:

Figure 4.11: The Piece Rate Wage Payment Systems Compared

3.2.2 Time Rate System

The payment under this plan is made in accordance with the time spent on the job. The time
may be on hourly, daily, weekly, fortnightly or monthly basis. For example, if the worker is
paid at the rate of Birr 20 per hour and he spends 50 hours during a week, the weekly
payment is:
Weekly wages = (Number of hours worked during the week) × (Rate per hours)
= 50 × 20 = Birr 1,000 per week.

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The main advantages of the time rate method include:
 Simple to calculate.
 Focus on punctuality, regularity and work.
 Less wastage, as worker is not unnecessarily worried about very high production
rate. The worker does not rush and spoil quality through a temptation of earning and
thus better quality of work is likely.
 Easy to operate in different situation.
 Consistency in calculation and approach.
 Workers feel assured of wages irrespective of machine failure, breakdown, etc.

The major disadvantages of time rate method are:

 Lack of motivation to do exceptional. The worker being assured of a fixed payment
for time spent is not tempt to work harder or more productively as he/she is not
rewarded for the extra time efforts.
 Requires close supervision as worker may waste production time. Intensive
supervision of workers, which create discomfort on workers, usually becomes a
necessity.
 Encourages inefficiency in workers – the “go slow” action or „shirking‟.

3.2.3 Wage-Incentive System

Organizations often use a combination of systems to provide greater flexibility in the pay
package to address particular needs. For instance they may have a basic rate for the job, with
a top-up increase that is self-financing, and an element for individual performance. There are
a wide range of the wage-incentive system, some following time-based approach and some
others following productivity-based approach.

The well-known incentive systems include those devised by Halsey, Rowan, Gantt, and
Emerson. They all provide incentive of varying degrees to increase output and in effort thy
link time and piece rate together. They have the following three features.

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 1. A standard time is fixed for specific tasks, determined by duration/time of work or
any other basis of average daily production. In some systems the task is relatively
easy and can be done in standard time by most workers while in others it is harder
and is within the reach of few workers only.
2. A bonus is paid to those who finish the task in the standard time or less than it.
Those workers who finish the task are thus entitled to the bonus in addition to the
hourly time rate for the task.
3. Workers who do not finish the task in the standard time will only be paid the hourly
rate but not penalized for failing to reach the standard. This is because though
individuals spend the same duration of work their average productivity indeed differs
greatly in reality.

The fairness and practical value of all bonus systems depend on the reasonableness of the
standard fixed and the wage, which workers of average ability can earn without forcing the
worker to work at excessive speeds. They can be abused if the standards are too high and
also if incentives/rewards are low in relation to workers effort. Such abuse and the fixing of
too low level straight or differential piece rates also defeat the system and reduce the
incentive system and create opposition among workers.

Unit Summary

1. Under perfectly competitive product and labor market, labor is paid its value of
marginal product, VMP.

2. When firms have some monopolistic and/or monopsonistic power in the product and/or
labor market, labor is paid less than its VMP and it is said to be exploited. Imperfection
in the product market alone results in monopolistic exploitation, and imperfection in
both markets results in monopsonistic exploitation. The latter is greater than former.

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3. In a bilateral monopoly, where a single seller faces a single buyer, the market solution is
indeterminate and wage rate (and employment) is determined by bargaining of the two
parties.

4. There are two major types of unions: industrial unions and trade unions (trade unions
are also known as craft unions). In general, unions would prefer to be operating in a
labor market in which labor demand is more inelastic. A labor union pursuing either a
collective bargaining agreement or restriction of labor supply, results in a higher wage
and a reduced level of employment. The difference is that in the second case there are
no unemployed workers in the market since the supply restriction prevents additional
workers from ever appearing in this market. The pure union wage advantage is the
percentage by which the union wage (Wu) exceeds the nonunion wage that would exist
without the union (Wn). The measured union wage advantage may overstate or
understate the pure advantage depending on which effects are dominant. If the spillover
and superior-worker effects are dominant, the measured union wage advantage will
overstate the pure advantage; if the threat and product-market effects are dominant, the
measured union wage advantage will understate the pure advantage.

5. The introduction of a minimum wage law that covers all employees into a perfectly
competitive labor market will be expected to result in a reduction in employment. If
there is a non-covered sector, introducing a minimum wage law will also create
economic inefficiency.

Review Questions

I. For Each of the Following Questions, Choose the Correct Answer

1. The labor supply curve for firm X is horizontal at the market-determined wage rate.
What is the reason for this?
A. The firm does not want to change the wage rate.

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 B. The government has fixed the wage rate.
C. The labor union has fixed the wage rate.
D. An individual firm is not large enough to affect the wage rate.
E. The marginal revenue product of labor does not vary.
2. If firm X is a monopsonist, then:
A. its marginal expense of hiring labor exceeds the wage rate it pays.
B. it is the only seller of a resource.
C. it is the only seller of a product.
D. it can cut the wage as it expands its work force.
3. An employer who is a monopsonist will probably:
A. hire more workers at a higher wage than a perfect competitor.
B. hire fewer workers at a lower wage than a perfect competitor.
C. hire fewer workers at a higher wage than a perfect competitor.
D. hire more workers at a lower wage than a perfect competitor.
4. A minimum wage imposed above a market clearing wage will result in:
A. the quantity demanded of labor being greater than the quantity supplied of labor and
unemployment will occur.
B. the quantity supplied of labor being greater than the quantity demanded of labor and
a shortage of workers will occur.
C. the quantity supplied of labor being greater than the quantity demanded of labor and
unemployment will occur.
D. the quantity demanded of labor being greater than the quantity supplied of labor and
a shortage of workers will occur.
5. Which of the following effects result in a measured union wage advantage overstating
the pure union wage advantage?
A. The threat effect and the spill-over effect
B. The spill-over effect and the product market effect
C. The threat effect and the product market effect
D. The spill-over effect and the superior-worker effect
E. The threat effect and the superior-worker effect

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6. In a bilateral monopoly model:
A. there is no equilibrium wage rate determined by the model.
B. the monopsonist‟s desire sets the upper limit of actual wage rate.
C. the monopolist‟s desire represents the upper limit of the actual wage rate.
D. the monopolist determines the lower limit of the wage rate.
E. A and C.

II. For Each of the Following Questions, Write True If the Statement Is
Correct and False If the Statement Is Wrong.

7. Craft unions attempt to organize all of the workers in an industry, regardless of the type
of work that is done.
8. If unions are able to convince the government to pass laws that give them control over
labor supply, there will not be unemployed workers in the market under consideration.
9. A minimum wage law that fixes above-market-clearing wages results in unemployment
and economic inefficiency if the labor market is perfectly competitive and there is a
non-covered sector.
10. As compared to a firm that is a perfect competitor in both labor and product markets, a
firm with some power in determining the price of its final product pays a lower wage;
and, this wage differential is a measure of monopsonistic exploitation.
11. Suppose initially the goal of a labor union was maximization of employment. Later on,
however, the union changes its goal to maximization of the total wage bill. Do you
think that the change in goal is beneficiary to both parties in the labor market? Why or
why not?

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 UNIT FIVE
WAGE DIFFERENTIALS AND LABOR QUALITY

Unit Introduction

We now have taken a close look at the supply and demand sides of the labor market. Putting
them together in a competitive market model gives us a theory of equilibrium wages (unit
four), as modified by possible monopsony power, unions, government regulation, etc.

However, the theory remains very abstract, for we have not really addressed a crucial issue:
explaining the large observed differences in pay across different workers, and different jobs
or occupations. Looking at the supply and demand diagram, we can see that wages will tend
to be higher in a job market if there is relatively less supply and/or relatively more demand.
Demand tends to be greater if the workers are more productive. But that doesn‟t explain how
they got to be that way. Maybe some workers are just born with more native talent.
Nevertheless, there are things people can do to enhance their productivity: education,
training, on-the-job learning, etc. What can we say more about the patterns of pay
differentials we observe in the labor market?

We will begin this unit with the discussion of a model of pay differentials known as the
theory of compensating wage differentials, or equal net advantage. We will then briefly
examine some other sources of wage differential. Finally, we will explore a model on the
role of education/training in the determination of earnings: the human capital model.

Unit Objectives

After a thorough study of this unit, you are expected to:

 explain why we observe wage differentials among workers using the arguments of
compensating wage differentials;

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  be able to point out factors that might contribute to the persistence of economically
unjustifiable wage differentials;
 understand what human capital comprises of, and appreciate the economic rational
behind investing in human capital; and
 comprehend the theory of human capital – a theory on how an optimal level of
investment in human capital is chosen – and discuss the limitations of the theory.

SECTION ONE: WAGE DIFFERENTIALS

Section Overview

SECTION ONE: WAGE DIFFERENTIALS

1.1 What Is Wage Differential?

1.2 Wage Differentials Due to Heterogeneous

Jobs

1.3 Wage Differentials Due to Heterogeneous

Workers

1.4 Wage Differentials Due to Labor Market

Imperfections

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1.1 What Is Wage Differential

A single wage rate would exist if both workers and jobs were homogenous, markets were
perfectly competitive, and mobility and migration were unimpeded. In such a situation,
workers would move among the various jobs until the wage paid in all markets were
identical. In the real world however, it is seldom seen that uniform level of wages is
established even in long run. On the contrary, one witnesses apparently permanent
differences in the wages paid in different occupations with hardly any significant movement
of labour form low paid occupations to highly paid ones. Wage differentials do exist and
many of them persist over time.

Wage differential refers to the payment of a different wage rates to different group of
workers. Wage differences may be vertical or horizontal. Vertical wage differences denote
the differences (in wages) in different grade of an occupation. Horizontal wage difference on
the other hand is that found among workers who do the same type of work, and workers who
have the same amount of skill training and efficiency. An example is wage difference that is
found between male and female workers in most parts of the world.

Wage differentials are attributed to three main categories of factors: heterogeneity of jobs,
heterogeneity of workers, and market imperfections.

1.2 Wage Differentials Due to Heterogeneous Jobs

Several non-wage aspects of jobs influence supply decisions in ways that generate
compensating wage differentials. Such wage differentials persist even in long run
equilibrium. These (compensating) wage differentials will remain between groups to
compensate for other differences between the jobs held by these groups. The theory of
compensating wage differentials explains differences in pay across different jobs as
reflecting differences in the non-wage costs and benefits associated with those jobs. Jobs
with non-wage characteristics that workers don‟t like will require higher pay to attract

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workers in the market. Jobs with non-wage characteristics that make the job relatively
attractive to workers will be able to pay workers relatively less. In this sense the competitive
labor market will compensate workers for undesirable non-wage job characteristics.
The theory of compensating wage differentials provides one explanation of wage differences
across individuals and across occupations. This theory suggests that wage differentials exist,
in part, to compensate workers for nonpecuniary characteristics of alternative types of
employment. Such differentials pay those who accept bad working conditions more than
they would otherwise receive.

There are a number of ways in which compensating wage differentials may arise:
 Job amenities and disamenities: jobs that are hard, dirty, dangerous, and in an
unsuitable geographical location will pay more, other things being equal, than
cleaner, safer and suitably located jobs. A wage premium may be required to induce
workers to fill them.
 Skill requirement of jobs: wages will be higher in jobs requiring more costly a priori
training (or investment in human capital).
 Efficiency wages: wages will be higher in jobs where it is difficult to monitor the
performance of workers, where costs to employers of mistakes by individual workers
are large, and where high labor turnover significantly reduces productivity.

Ceteris paribus, it would be expected that a similar compensating wage differential would
exist for differences in working conditions, job stress, educational requirements, and other
characteristics of jobs that make them either more or less desirable. It is expected that more
pleasant jobs will offer lower wages than less pleasant jobs, holding all other job
characteristics constant.

Although differences in non-wage job amenities, variation is skill requirements of

alternative employment, and efficiency wage payments appear to be the major
heterogeneities of jobs that create wage differentials, several other job or employer

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differences may contribute to this phenomenon. For instance, jobs or employers differ on
such things as:
 union status,
 tendency to discriminate, and
 absolute and relative firm size.

Union – non-union wage differential includes, besides some justifiable factors, an economic
rent deriving from the ability unions to exert market power. Direct discrimination may also
occur in some labor markets as some employers are biased toward or against hiring certain
classes of workers. Large firms or those with major market shares generally pay higher
wages and salaries than smaller firms.

There are various possible explanations for this:

1. large firms are generally more likely to be unionized than smaller firms;
2. workers in larger firms may be more productive than workers in small enterprises
due, among others, to more on-job-training necessitated by skill specialization;
3. larger firms may be more bureaucratic and less pleasant place to work than smaller
companies and thus the larger wage paid by larger firms is a compensating wage
premium;
4. large firms are more likely to be located in major metropolitan areas, where overall
living costs are higher ….

1.3 Wage Differentials Due to Heterogeneous Workers

Having observed that heterogeneities among jobs and employer constitute a major source of
wage disparities, we now turn to an equally important factor influencing the wage structure:
heterogeneous workers. People are not homogeneous. They possess differing stocks of
human capital. At any point in time, the labor force consists of numerous non-computing
groups, each one of which represents one or several occupations for which the member of
the group qualify.

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People have differing stocks of human capital according to native endowment and the type,
amount, and quality of education and training they possess. Unsurprisingly, the result is a
wide variety of groups, sub-groups, or even individuals who are not readily substitutable for
one another in the labor market. In the short run, these human capital heterogeneities
produce wage differentials due to the varying productivity of workers.

In addition to possessing differing stocks of human capital, people also are heterogeneous
with respect to their preference for such things as: (i) present versus future income, and (ii)
various non-wage aspects of work.

1.4 Wage Differentials Due to Labor Market Imperfections

Wage differentials can be explained largely – but not fully – on the basis of heterogeneous
jobs, employers, and workers. They also occur because of labor market imperfections that
impede labor mobility. Such factors as imperfect information, costly migration, and various
other barriers to mobility interact to create and maintain wage differentials.

The fact that information is imperfect and increasingly costly to obtain has important
implications for labor market activity and the wage structure. Specifically, it implies that:
1. range of wage rates may exist for any given occupation, independently of
compensating differentials, and
2. when changes in demand cause wage differentials, long run supply adjustments are
likely to be slow.

Labor immobilities, defined simply as impediments to the movement of labor, constitute

another major reason that wage differentials occur and sometimes persist. These barriers to
labor mobility may be classified as geographic, institutional, and sociological.

Workers move if the expected present value of the net benefits is positive. When there are
no costs of mobility, the law of one price would apply in labor markets. Workers shift from

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job to job until the wage rate is the same everywhere for workers with a given mix of skills
and abilities. Mobility costs, however, give firms some degree of monopsony power in labor
markets. If these costs deter migration to the extent that an insufficient number of migrants
are attracted to the higher-paying locale, geographic wage differentials will persist.

Restrictions on mobility imposed by such institutions as government and unions may

reinforce geographic immobilities. Government licensing of occupations can restrict the
movement of qualified workers among jobs. Other institutional immobilities involve
pension plans and seniority rights, which reduce peoples‟ incentives to move from one job
to another.

There are also various sociological barriers to labor market mobility. These include labor
market discrimination by race and gender. For instance, to the extent that there are barriers
that keep qualified women from moving away from lower-paying positions to higher-paying
occupations, wage differentials between sexes can persist.

Section Reflection

1. Discuss the major factors which explain the wage differentials that we observe in the
real world.
2. Which of these factors do you think are more appealing? Why? (try to relate your
discussion to your observation of local labor markets).

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SECTION TWO: LABOR QUALITY

Section Overview

SECTION TWO: LABOR QUALITY

2.1 Investment in Human Capital

2.2 On-the-job Training

2.3 Criticisms of the Human Capital Theory

2.1 Investment in Human Capital

The positive relationship between the level of education and the level of earnings is one of
the most robust relationships observed by labor economists. Typically, this relationship is
explained using the human capital model. Human capital, in this model, can be thought of as
a measure of an individual's productive capacity. Under the human capital model, it is
assumed that the level of an individual's earnings is determined by the individual's stock of
human capital. An individual can increase his or her human capital by investments in:
formal education, on-job-training, or health care.

For now, we'll focus on the first of these types of investment. Most economic models of
educational attainment are based on the assumption that individuals select the level of
educational attainment that results in the highest expected present value of lifetime earnings
(net of educational costs). Simply stated, this means that a person will attend college only if

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the present value of the expected benefits exceeds the present value of the expected costs
associated with this choice.

2.1.1 Costs of Education

There are three types of costs associated with (a college) education:

 direct costs such as tuition, books, and supplies,
 forgone earnings (the opportunity cost of time), and
 psychic costs.

Notice that the direct costs include only those direct expenditures that a student would make
only if he or she attends college. The costs of meals, dorm fees, etc., would not generally be
a cost of education since these individuals would face costs of meals and lodging if they had
been engaged in some alternative use of time (such as working). Room and board fees
would partially enter as a cost only if these costs are higher than they would have been under
the next-best alternative use of time.

As noted earlier, the forgone earnings associated with being a full-time student is usually the
largest cost associated with acquiring a college or advanced degree.
The psychic costs associated with attending college include the stress, anxiety, and
sometimes boredom associated with classes, exams, assignments, papers, etc.

2.1.2 Benefits of Education

The benefits associated with acquiring a college degree include:

 higher expected earnings,
 more pleasant jobs,
 lower expected unemployment rates, and
 psychic benefits.

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In general, college graduates receive not only higher pay, they also receive jobs that are
more secure and involve less tedious work, less physical work, more pleasant work
environments, better working conditions, higher social status, and so forth. The psychic
benefits associated with education include the enjoyment that may be received by being in
the college environment.

2.1.3 Optimal Investment in Education

An individual will acquire additional education as long as the present value of the marginal
benefits from this additional education outweighs the present value of the marginal costs.
Those individuals who have higher benefits and/or lower costs will acquire more education.
The diagram below illustrates the effect of changes in MC and MB on the optimal level of
human capital investment.

Figure 5.1: The Effect of Changes in MC and MB on the Optimal Level of Human
Capital Investment

The nature of the trade-off can be seen in the following diagram, which shows the
hypothetical costs and benefits of a college degree over a person‟s lifespan. Earnings stream

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A represents the path of annual earnings of the person if they do not attend college. Earnings
stream B represents the path of earnings for the same person if they obtain a four-year
college degree. Direct costs of education are represented below the X (age) axis.

Figure 5.2: Benefits and Costs of College over the Life Cycle

Thinking about education as an investment gives us a simple rule for optimal investment: A
person should continue to invest in one more year of education as long as the marginal
benefit of one more year exceeds the overall marginal cost (MB > MC).

This rule has several implications:

 Schooling is for the young. The earlier a person obtains their education, the more
years they will be able to benefit from the higher earnings. From a pecuniary point of
view, it makes little sense for a person to gain new marketable skills when they are
close to retirement age.

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  Investment in education should be greater to the extent that the costs are lower. Thus
for example government subsidies of education would make it more attractive to an
individual by reducing the direct costs of attending school.
 Investment in education should be greater to the extent that the gap in earnings
between more and less educated workers is greater. This makes the benefits bigger.
 Individuals should be willing to invest more in education to the extent that they are
more “forward-looking.” That is, a person who is willing to wait to get the returns
places greater value on the benefits of higher earnings than a very impatient
individual.

These predictions are generally consistent with the evidence. Most people obtain most of
their education when they are young. Subsidizing schooling tends to increase school
attendance. And there is evidence that during periods when the wage gap between the more
and less educated is very large (such as it is today), people choose to stay in school
somewhat longer, other things equal.

The human capital model suggests that the level of human capital investment is affected by:
 interest rates,
 the age of the individual,
 the costs of education, and
 the wage differential between high school and college graduates.

Since most of the benefits associated with a college degree occur relatively later in the
lifecycle while the costs are borne more immediately, an increase in the interest rate facing
an individual will be expected to lower the net benefit of education. (This occurs because an
increase in the interest rate lowers the present value of more distant benefits and costs by
more than it lowers the benefits of short-term benefits and costs.) Government subsidized
student loan programs are designed to reduce interest rate differentials across households.
(In the absence of these subsidized interest rates, low-income households would face

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substantially higher interest rates, resulting in a lower probability that children from such
households will attend college.)

It is expected that individuals will tend to invest more in education at an earlier stage of their
lifecycle because this results in a larger period over which the increased earnings may be
realized. (Exceptions to this often occur when individuals change careers.)

The theory discussed above, of course, directly predicts that more people will attend college
when the costs are lower and/or the benefits are higher.

Age-Earnings Profiles

Age-earnings profiles, for a given level of educational attainment, are generally concave.
This means that earnings increase at a progressively slower rate as the individual ages
(holding constant the level of educational attainment). The simplest explanation for this is
that individuals invest in a larger quantity of on-the-job training at earlier stages of their
work-life. This is usually depicted using the Wage-Schooling Locus. The wage-schooling
locus gives the wage that employers are willing to pay for every schooling level. It is
determined by supply and demand of workers for a given schooling level. Besides, it is
upward sloping and concave, reflecting the fact that there are diminishing returns to
education.

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 Figure 5.3: Wage-Schooling Locus

Evidence also suggests that those who invest in more education also invest in a larger
amount of on-the-job training (for similar reasons). This results in a widening in the gap in
earnings across educational levels as individuals age.

Gender, Education, and Age-Earnings Profiles

One of the reasons for the historically lower level of educational attainment for females is
that females tended to have significantly shorter expected work-lives than males. In recent
years, however, increases in female labor force participation have narrowed the gap in
expected work-life between males and females. This increase in expected work-life is one of
the reasons for the rather dramatic increase in female college enrollment rates in recent
decades.

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Does College Attendance Pay Off?

Estimates of the rate of return to education are determined by comparing the expected
lifetime earnings streams that an individual could receive under alternative levels of
educational attainment. Roughly speaking, estimates of this rate of return to a bachelor‟s
degree are derived by comparing the earnings streams of college graduates with the earnings
streams of high school graduates who have equivalent observable characteristics. Numerous
studies suggest that this rate of return has increased in recent years.

There are, however, a few potential sources of bias in these estimates. If college graduates
differ from high school graduates in terms of unobservable differences in ability or
motivation, those who attend college might have received higher earnings even if they had
not attended college. The same argument suggests that high school graduates would not earn
as much as college graduates do if they had instead chosen to attend college. In this case, the
return to education would overstate the increase in earnings that would be received by
individuals. This type of bias, called "ability bias," suggests that the observed difference in
earnings between high school and college graduates overstates the return to education that
would be received by a given individual.

The return to education, however, may be understated by a comparison of the earnings of

high school and college graduates as a result of the non-pecuniary returns received from
education. Some of the benefits from education involve increased productivity in non-
market activities. College graduates also receive more pleasant jobs. These non-pecuniary
benefits from education result in a smaller wage difference between high school and college
graduates than would have been received if their jobs were equivalent in all dimensions
except for the wage. (To see this, recall the theory of compensating wage differentials
discussed in section one of this chapter).

Still another possibility involves the existence of selectivity bias. Some researchers found
that those who attend college perform relatively well in the types of jobs that college

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graduates receive while those who do not attend college perform relatively well in the types
of jobs that high school graduates receive. This suggests, for example, that a good lawyer
may be a poor carpenter while a good carpenter may be a poor lawyer. In this case, the
return to college is relatively large for those who attend college for two reasons: they do
well in the types of jobs that college graduates receive while they would have received
relatively low wages if they had not gone to college. Their results also suggest that the
return to education is relatively low for those who choose to not attend college.

2.2 On-the-job Training

Although there are good reasons for investing in human capital early in life, accumulation of
human capital doesn‟t end with formal schooling. Perhaps the most important source of
increases in human capital after formal schooling is learning on the job, whether through
formal training or learning by doing.

As we have seen, earnings tend to increase with age, which many economists attribute to the
accumulation of human capital through work experience. Furthermore, this age-earnings
profile tends to be convex. That is, earnings increase over the life cycle, but at a declining
rate. The convexity is consistent with the human capital model, because most of the
investment in on-the-job training, like investment in schooling, should occur early in life, so
as to lengthen the period during which one receives the returns. Thus skills increase at a
declining rate.

We can distinguish two kinds of training that occur on the job: general and specific.
 General training results in skills (general human capital) that can be transferred to
and have value with other employers.
 Specific training results in skills (specific human capital) that are only of value to a
single employer.

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There are costs associated with on-the-job training, even though the individual is working,
producing, and earning as she or he learns. Generally during any learning process the worker
is less productive than they would be if their entire energies and attention were focused on
getting the job done. The benefits of training take the form of higher productivity later on.
The following diagram shows the paths of productivity over a worker‟s career, with and
without training on the job.

Figure 5.4: The Paths of Productivity over a Worker’s Career with and without On-Job-
Training

Without training, the worker‟s productivity is constant over her career. With training,
productivity increases over time (at a decreasing rate, given our prediction that more
investment in training occurs early in the career).

An interesting question is who pays the costs associated with training on the job, and who
reaps the benefits: the employer or the employee? If the employee paid for all the training

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and received all the benefits, her earnings would follow her productivity exactly, starting
low (below what she would earn if she weren‟t training) and rising over time. If the
employer paid all the costs and received all the benefits, the worker‟s earnings would be
constant (follow the dashed line). The employer would then be paying the worker more than
she was worth (in productivity terms) early in her career and less than she was worth later
on. If the worker and employer shared the costs and benefits, the path of pay would lie
somewhere between the two pay profiles.

Economic theory predicts that the worker (employee) must usually pay for any general
training. The reason is that the skills are transferable, so the employee can retain all the
benefits of the training should she change employers. Therefore, the employer would not
normally be willing to pay for that training. The fact that a worker pays all the costs and
receives all the benefits of general raining implies that her pay over time should closely
follow her productivity. Because the worker can use this training to increase productivity at
many firms, the employer won‟t pay; worker must pay with reduced wages during training
but then benefits with increased wage after training.

In contrast with the case of general training, workers and their employers share the costs and
benefits of specific training. Since the training is specific to the firm, the worker can‟t “take
it with him”. So, the firm should be willing to pay for it. But, the worker will then reap
some of the benefits of the increased productivity post-training. When there are specific
skills, therefore, both the employee and employer have an incentive to reduce turnover,
because both parties would lose their investment in specific human capital if they separated.
If workers bear the costs, there is no reason for the firm to keep the worker. If firms bear the
costs, there is no reason for workers to stay.

The sharing of the costs and benefits of specific training helps accomplish this goal. To the
extent that the worker is paid more because of her specific skills, she has less incentive to
leave for another job, where her specific skills would have no value. But because the

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employer is not paying her the full value of her added productivity, the employer has an
incentive to keep the worker.

2.3 The Cobweb Model of Educational Attainment

The cobweb model is used to explain the behavior of price and quantity over time when a
lagged supply response occurs. This model is appropriate in labor markets in which the
minimum educational qualifications for a job include several years of college or technical
training. The diagram below represents such a market. The supply curve in this market
represents the quantity of labor that will be supplied at each wage after workers have enough
time to complete the educational requirements. Initially, this market is assumed to be in a
state of long-run equilibrium at a wage of w and a level of employment equal to L.

Figure 5.5: Labor Market Equilibrium

Suppose the demand for labor increases to D'. In the short run, the quantity of labor
available in this market is fixed at L (since it takes time for new workers to receive the
training necessary to enter this labor market). Thus, the short-run effect of an increase in

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labor demand is an increase in the wage rate to w' (with no change in the quantity of labor
employed). This short-run change in the wage (at the initial level of employment) is
represented by the arrow in the diagram below.

Figure 5.6: The Effect of an Increase in Labor Demand on Wages

In response to this higher wage, however, a relatively large number of workers will chose to
acquire training in this field. As the diagram below indicates, the quantity of labor supplied
will ultimately increase to L' at a wage of w'.

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 Figure 5.7: The Effect of an Increase in Wage on Labor Supply

Once all of these newly trained workers enter this market, however, the short-run labor
supply curve will be fixed at a quantity of L'. Given this new short-run labor supply curve,
the equilibrium wage will fall to w''.

Figure 5.8: The Effect of an Increase in Labor Supply on Wages

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At this new lower wage of w'', however, students entering college will choose to major in
other fields and the number of workers in this market will ultimately fall to L''.

Figure 5.9: The Effect of a Decrease in Wages on Labor Supply

Now that the short-run supply curve has fallen to L'', however, the wage rate will increase to
w''' (as illustrated below).

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 Figure 5.10: The Effect of a Decrease in Labor Supply on Wages

This process continues until a new long-run equilibrium is reached at w* and L* (assuming,
of course, that there are no further shifts in either labor demand or supply....).

Figure 5.11: The Long-Run Effect of an Increase in Labor Demand on Labor Market
Equilibrium

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The diagram above should suggest why this model is referred to as a "cobweb model."

2.4 Criticisms of the Human Capital Theory

If college graduates differ from high school graduates in terms of unobservable differences
in ability or motivation, those who attend college might have received higher earnings even
if they had not attended college. The same argument suggests that high school graduates
would not earn as much as college graduates do if they had instead chosen to attend college.
In this case, the return to education would overstate the increase in earnings that would be
received by individuals. This type of bias, called "ability bias," suggests that the observed
difference in earnings between high school and college graduates overstates the return to
education that would be received by a given individual.

Secondly, education may not raise any worker's productivity. Instead, it allows firms to sort
workers according to their productivity. The signaling model suggests that firms cannot
directly measure the productivity of individual workers (at least not when they are initially
hired). Over time, though, firms observe that college graduates are more productive than
high school graduates. This results in higher pay for college graduates and lower pay for
high school graduates (as compared to a situation in which this educational "signal" did not
exist). Accordingly, the benefits to a college degree are the same for all workers (since all
workers with a college degree receive the higher pay). Low ability individuals, however, are
assumed to face higher costs of education (it requires more time and effort for a low ability
worker to make it through a bachelors degree). Thus, education only signals that an educated
worker has high ability to find it profitable to attend college.

The return to education, however, may be understated by a comparison of the earnings of

high school and college graduates as a result of the non-pecuniary returns received from
education. Some of the benefits from education involve increased productivity in non-
market activities. College graduates also receive more pleasant jobs. These non-pecuniary
benefits from education result in a smaller wage difference between high school and college

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graduates than would have been received if their jobs were equivalent in all dimensions
except for the wage.

Finally, while human capital theory considers all expenditure on education as investment
cost, a portion of the total expenditure on education could actually be consumption
expenditure. Education in itself could be seen as one of consumer goods, and may enter the
utility function of individuals directly. Consequently, not all of the expenditure on education
is investment expenditure.

Section Reflection

1. Given the arguments of human capital theory, what factors affect your decision to invest
in education? Group these factors under costs and benefits.
2. Why is it the case that employees should cover the cost of general training?
3. What are the shortcomings of the human capital model?

Unit Summary

1. Wage differentials are attributed to three main categories of factors: heterogeneity of

jobs, heterogeneity of workers, and market imperfections.

2. The theory of compensating wage differentials explains differences in pay across

different jobs as reflecting differences in the non-wage costs and benefits associated
with those jobs. Jobs with non-wage characteristics that workers don‟t like will require
higher pay to attract workers in the market.

3. People have differing stocks of human capital according to native endowment and the
type, amount, and quality of education and training they possess. Besides, people are
heterogeneous with respect to their preference for such things as present versus future
income, and various non-wage aspects of work. These human capital heterogeneities

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 and differences in tastes and preferences produce wage differentials due to the varying
productivity of workers.

4. Wage differentials also occur because of labor market imperfections that impede labor
mobility. Imperfect information, costly migration, and various other barriers to mobility
interact to create and maintain wage differentials.

5. Human capital can be thought of as a measure of an individual's productive capacity.

An individual can increase his or her human capital by investments in: formal
education, on-job-training, or health care.

6. An individual will acquire additional education as long as the present value of the
marginal benefits from this additional education outweighs the present value of the
marginal costs. Those individuals who have higher benefits and/or lower costs will
acquire more education. Most people obtain most of their education when they are
young. Subsidizing schooling tends to increase school attendance. And there is evidence
that during periods when the wage gap between the more and less educated is very large
(such as it is today), people choose to stay in school somewhat longer, other things
equal. While Economic theory predicts that the worker (employee) must pay for any
general training, workers and their employers share the costs and benefits of specific
training. The theory of human capital has been criticized in different ways

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Review Questions

I. For Each of the Following Questions, Choose the Correct Answer

1. One of the following does not reflect wage differential due to heterogeneity of jobs or
employers.
A. Compensating wage differentials
B. Differing skill requirements
C. Discrimination
D. Non-competing groups
E. None of the above
2. Criticisms of human capital theory include all of the following except:
A. Higher earnings of more-educated workers could be attributed (at least partly) to
schooling serving as a means of signaling (or screening).
B. A substantial portion of the incremental earnings enjoyed by the more-educated
workers could be attributed to their ability and not to their schooling.
C. A portion of the total expenditure on education is consumption expenditure, and not
all of it is investment expenditure.
D. Only wage differentials are considered in the return to education and non-wage
benefits are ignored.
E. None of the above.

II. For Each of the Following Questions, Write True If the Statement Is
Correct and False If the Statement Is Wrong.

3. One justification for public subsidization of human capital investments is that the money
market usually provides funds for human capital investment on less favorable terms
than for investments in physical capital.
4. Impediments to the movement of labor help explain persistent earnings differences
among workers.

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5. Wage differences could be fully explained on the basis of heterogeneous jobs,
heterogeneous employers, and heterogeneous workers.
6. Efficiency wage theories predict that wages will be higher where it is difficult to monitor
the performance of workers, where the costs to employers of mistakes by individual
workers are large, and where higher labor turnover significantly reduces productivity.

III: For Each of the Items under Column A, Choose the Match from the
Items under Column B.

A B
7. Wage differentials due to heterogeneous A. Differences in time preferences of
jobs workers
8. Wage differentials due to heterogeneous B. Specific training
workers C. Fringe benefits
9. The employee and the employer share the D. General training
training cost
10. The employee pays the training cost

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 UNIT SIX
JOB SEARCH AND UNEMPLOYMENT

Unit Introduction

The unit on wage differentials and labor quality has shown us that there are different wage
rates in the market, as opposed to the single equilibrium wage rate of the neoclassical labor
market theory. This in turn justifies workers search for better pays and work conditions and
firms search for best quality workers. We will take the issue of job search in the first section
of this unit.

Losing a job can be the most distressing economic event in a person‟s life. Most people rely
on their labor earnings to maintain their standard of living, and many people get from their
work not only income but also a sense of personal accomplishment. A job loss means a
lower living standard in the present, anxiety about the future, and reduced self-esteem. It is
not surprising, therefore, that politicians campaigning for office often speak about how their
proposed policies will help create jobs.

An obvious determinant of a country‟s standard of living is the amount of unemployment it

typically experiences. People who would like to work but cannot find a job are not
contributing to the economy‟s production of goods and services. Although some degree of
unemployment is inevitable in a complex economy with thousands of firms and millions of
workers, the amount of unemployment varies substantially over time and across countries.
When a country keeps its workers as fully employed as possible, it achieves a higher level of
GDP than it would if it left many of its workers standing idle.

We begin the second section of this unit by looking at some of the relevant facts that
describe unemployment. In particular, we examine three questions: How do we measure the
economy‟s rate of unemployment? What problems arise in interpreting the unemployment

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data? How long are the unemployed typically without work? We then turn to the reasons
why economies always experience some unemployment. As we will see, long run
unemployment does not arise from a single problem that has a single solution. Instead, it
reflects a variety of related problems. As a result, there is no easy way for policymakers to
reduce the economy‟s natural rate of unemployment.

Unit Objectives

After studying this unit, students are expected to:

 understand the importance of job search in the labor markets;
 comprehend the characteristics of external and internal labor markets;
 define unemployment and discuss the difficulties in measuring it;
 distinguish among the different types of unemployment and the differing views on the
issue of unemployment; and
 be able to forward some government policies for reducing unemployment.

SECTION ONE: JOB SEARCH

Section Overview

SECTION ONE: JOB SEARCH

1.1 What Is Job Search?

1.2 External Job Search

1.3 Internal Labor Markets and Job Search

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1.1 What Is Job Search?

As we will see in a later section, one reason why economies always experience some
unemployment is job search. So, we must first define job search and investigate its features.

Job search is the process of matching workers with appropriate jobs. If all workers and all
jobs were the same, so that all workers were equally well suited for all jobs, job search
would not be a problem. Laid-off workers would quickly find new jobs that were well suited
for them. But, as we saw in Unit Five, workers differ in their tastes and skills, jobs differ in
their attributes, and information about job candidates and job vacancies is disseminated
slowly among the many firms and households in the economy.

Individuals search for jobs for a variety of reasons. Firms may suffer a decrease in demand
and lay-off workers who then search for new employment. New high school and college
graduates will search for their first (permanent) employment. Individuals who dropped out
of the labor force to raise children may re-enter the job market. Workers may search for jobs
that are a better match with their abilities. For a given occupation, earnings and other
working conditions differ widely within a city or even a firm. As a result, workers search for
jobs that offer them better combinations of wages and job characteristics.

Thus, job search is a natural and often constructive occurrence in a dynamic economy
characterized by heterogeneous workers and jobs and by imperfect information

The job search process could be conveniently analyzed in two categories – external job
search and internal job search. External job search is concerned with how workers attempt to
find jobs at a new employer (firm). Internal job search, on the other hand deals with the
issue of job search within a firm.

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1.2 External Job Search

Two major characteristics of the labor market contribute to the need for people to search for
the best job offer and for firms to search for employees to fill job vacancies. These are:
1. Workers and jobs are highly heterogeneous
2. Market information about such differences in workers and jobs is imperfect and takes
time to obtain.

Consequently, job seekers and prospective employers find that it in their respective interests
to search for information about each other as a way to improve the terms of the transaction.
Acquiring job information involves expected gains and costs. These gains and costs are
usually examined a job search model. In this model, we assume that there is an unemployed
job seeker who recognizes that the heterogeneous nature of jobs and employers, together
with imperfect market information, generates a wide variance of likely wage offers for
his/her occupation. We also assume that this person can roughly estimate the mean and
variance of the frequency distribution of wage offers but has no way of knowing which
employer has a job opening or which employer is offering which wage.

How will job search benefit this job seeker? Because this person is unemployed, he/she does
not have an immediately available wage opportunity. A job search allows people to obtain
wage offers and increase the likelihood of discovering wage opportunities.

What are the costs of gaining job information? They include fees paid to employment
agencies, transportation costs to and from interviews and costs for reading vacancies in
newspapers and other publications. But, job search also includes significant opportunity
costs. For instance, suppose our job seeker searches for one job offer at a time, either getting
an offer or not, and if he gets an offer, either accepting it or rejecting it before continuing to
search for other offers. If this person receives and rejects an offer, that wage opportunity is
lost; most wage offers cannot be stored. Therefore, a major cost of continuing job search is

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the foregone earnings of the best known opportunity. As higher wages are received, the
marginal cost of continued search rises.

One decision rule this job seeker might employ in accepting or rejecting a particular job
offer begins by defining the person‟s reservation wage an acceptance wage. If the person
knows the frequency distribution of the wage offers in the market, and can estimate the cost
of generating new job offers, he/she can find the wage that equates the expected marginal
benefit (MB) and expected marginal cost (MC) from search – the acceptance wage. If the
job seeker is offered a wage rate above this acceptance wage, he/she will conclude that it is
not worthwhile to continue searching (MB < MC). If offered a wage rate below this amount,
the person will reject the offer and continue to look for new offers, because the expected
marginal benefit of the activity exceeds the expected marginal cost (MB > MC).

The following are the main implications of the job search model we saw above:
 The faster information spreads about job openings and worker availability, the more
rapidly the economy can match workers and firms. The Internet, for instance, may
help facilitate job search and reduce frictional unemployment. In addition, public
policy may play a role. If policy can reduce the time it takes unemployed workers to
find new jobs, it can reduce the economy‟s natural rate of unemployment.
 Fully anticipated inflation has no impact on the optimal length of job search because
job seekers will adjust their acceptance wages upward at the same rate as nominal
wage offers rise.
 If job searchers mistakenly view inflation-caused rises in nominal wage offers as real
wage increases, they will shorten their job search, and unemployment will
temporarily fall.
 Unemployment compensation/insurance – a welfare payment to unemployed people
often based on an insurance scheme – creates a disincentive for job search. Because
unemployment benefits stop when a worker takes a new job, the unemployed devote
less effort to job search and are more likely to turn down unattractive job offers. In
addition, because unemployment insurance makes unemployment less difficult,

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 workers are less likely to seek guarantees of job security when they negotiate with
employers over the terms of employment.

1.3 Internal Labor Markets and Job Search

Evidence indicates that many people work for the same employer for numerous years and, in
effect, search for improved pay and job characteristics through promotions and
reassignments within their existing firms. Most firms and plants embody internal labor
markets in which wages and the allocation of labor are determined by administrative rules
and procedures rather than strictly by supply and demand (the notion of auction markets).

An internal labor market is an administrative unit, such as a manufacturing plant, within

which the pricing and allocation of labor is governed by a set of administrative rules and
procedures rather than by economic variables. Within many firms, there are hierarchies of
jobs, each of which entails a sequence or progression of jobs that forms what is called a
mobility chain or job ladder. A new worker will typically enter this job ladder as a trainee in
the least-skilled job at the bottom of the ladder. The position at which workers gain access to
the job ladder, is called a port of entry. It is through this port of entry that the sequence of
jobs that constitutes the job ladder makes contact with the external labor market.

The external labor market is the auction market of the neoclassical theory. That is, in
recruiting workers to fill vacancies for the least-skilled position in a job ladder, the firm
must compete with other firms that are hiring the same kind of labor. Except for the port of
entry position, market forces are held to be replaced by administrative rules and procedures
in explaining the wages paid for other jobs constituting the job ladder of internal labor
markets.

Internal labor markets exist because they generate advantages for both employers and
workers. For employers, internal labor markets reduce worker turnover and thereby increase
the return on specific training and reduce recruitment and training costs. For workers,

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internal labor markets provide job security, opportunities for training and promotion, and
provide protection from arbitrary managerial decisions.

Some economists argue that internal labor markets contribute to inefficiency because wages
are determined by rigid administrative procedures and rules. They argue that various kinds
of workers are not paid in accordance with their productivities (if not by chance), because
workers are shielded from competition and wages are based on arbitrary evaluations, custom
and tradition.

Other economists argue that internal labor markets enhance productivity by:
 reducing recruitment, screening, and training costs;
 inducing senior workers to share their skills and knowledge with junior workers
through providing a greater amount of security to the senior ones; and
 providing younger workers with greater incentives to work productively and signal
that they should be retained in the firm deserve to progress up the job ladder.

Section Reflection

1. What difference/s do you see between internal and external labor markets? Discuss!
2. How does the presence or absence of insurance benefits affect job search incentives?
3. Discuss the efficiency implications of internal labor markets.

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SECTION TWO: UNEMPLOYMENT

Section Overview

SECTION TWO: UNEMPLOYMENT

2.1 Definitions and Measure of Unemployment

2.2 Types of Unemployment

2.1 Definitions and Measure of Unemployment

The labor force of an economy does not include the entire population but only those who are
in the working age (15 to 64 years old in Ethiopia), employed, or unemployed and looking
for work. A working-age person who is not looking for work is considered voluntarily
unemployed and is not included in the labor force. Thus, the size of the labor force and the
number of people unemployed can be understated when a significant number of workers,
after some searching, become discouraged and stop looking for work.

Unemployment refers to the state of being part of a labor force, wanting to work, but
without a job. An alternative definition of unemployment describes it as a disequilibrium
phenomenon arising from inflexible prices.

The unemployment rate is the percent of the total labor force that is unemployed.
number of unemployed
Unemployment Rate (%)   100
size of the labor force

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Unemployment has been measured both as a stock and as a flow, using as statistical sources
registers of persons declaring themselves to be unemployed and household surveys.
Measuring the amount of unemployment in the economy might seem straightforward. In
fact, it is not. Whereas it is easy to distinguish between a person with a full-time job and a
person who is not working at all, it is much harder to distinguish between a person who is
unemployed and a person who is not in the labor force.

Unemployment statistics refer to data on the total numbers within a country‟s labor force
without a job but seeking employment. It is customary to subdivide this information by sex,
age, industry, occupation and duration of unemployment. Governmental bodies charged
with the task of collecting these data constantly attempt to refine their definition of
unemployment to obtain a more accurate measure: by doing so, they invite the accusation
that they are distorting the figures.

Movements into and out of the labor force are, in fact, very common. Entrants include
young workers looking for their first jobs, such as recent college graduates. They also
include, in greater numbers, older workers who had previously left the labor force but have
now returned to look for work. Moreover, not all unemployment ends with the job seeker
finding a job. Much of the spells of unemployment end when the unemployed person leaves
the labor force. Unemployment spell is a completed period of unemployment. Spells are
likely to be longer at higher levels of benefit, when workers have savings and when the
overall rate of unemployment is high.

Because people move into and out of the labor force so often, statistics on unemployment
are difficult to interpret. On the one hand, some of those who report being unemployed may
not, in fact, be trying hard to find a job. They may be calling themselves unemployed
because they want to qualify for a government program that financially assists the
unemployed or because they are actually working and being paid “under the table.” It may
be more realistic to view these individuals as out of the labor force or, in some cases,
employed. On the other hand, some of those who report being out of the labor force may, in

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fact, want to work. These individuals may have tried to find a job but have given up after an
unsuccessful search. Such individuals, called discouraged workers, do not show up in
unemployment statistics, even though they are truly workers without jobs.

There is no easy way to fix the unemployment rate to make it a more reliable indicator of
conditions in the labor market. Thus, it is best to view the reported unemployment rate as a
useful but imperfect measure of joblessness.

The problem of unemployment is usefully divided into two categories – the long-run
problem and the short run problem. The economy‟s natural rate of unemployment refers to
the amount of unemployment that the economy normally experiences. Cyclical
unemployment refers to the year-to-year fluctuations in unemployment around its natural
rate, and it is closely associated with the short-run ups and downs of economic activity. The
designation natural does not imply that this rate of unemployment is desirable. Nor does it
imply that it is constant over time or impervious to economic policy. It merely means that
this unemployment does not go away on its own even in the long run.

The economy always has some unemployment and that the amount changes from year to
year. The normal rate of unemployment around which the unemployment rate fluctuates is
called the natural rate of unemployment, and the deviation of unemployment from its natural
rate is called cyclical unemployment. The natural rate of unemployment is the single rate of
unemployment compatible with a constant rate of inflation. Equivalently, it is the long-term
rate of unemployment around which an economy fluctuates as expectations of wage and
price changes are fully realized by the associated rate of inflation.

In judging how serious the problem of unemployment is, one question to consider is whether
unemployment is typically a short-term or long-term condition. If unemployment is short-
term, one might conclude that it is not a big problem. Workers may require a few weeks
between jobs to find the openings that best suit their tastes and skills. Yet if unemployment

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is long-term, one might conclude that it is a serious problem. Workers unemployed for many
months are more likely to suffer economic and psychological hardship.

Because the duration of unemployment can affect our view about how big a problem
unemployment is, economists have devoted much energy to studying data on the duration of
unemployment spells. In this work, they have uncovered a result that is important, subtle,
and seemingly contradictory: Most spells of unemployment are short, and most
unemployment observed at any given time is long-term.

To see how this statement can be true, consider an example. Suppose that you visited the
government‟s unemployment office every week for a year to survey the unemployed. Each
week you find that there are four unemployed workers. Three of these workers are the same
individuals for the whole year, while the fourth person changes every week. Based on this
experience, would you say that unemployment is typically short-term or long-term?

Some simple calculations help answer this question. In this example, you meet a total of 55
unemployed people; 52 of them are unemployed for one week, and three are unemployed for
the full year. This means that 52/55, or 95 percent, of unemployment spells end in one week.
Thus, most spells of unemployment are short.

Yet consider the total amount of unemployment. The three people unemployed for one year
(52 weeks) make up a total of 156 weeks of unemployment. Together with the 52 people
unemployed for one week, this makes 208 weeks of unemployment. In this example,
156/208, or 75 percent, of unemployment is attributable to those individuals who are
unemployed for a full year. Thus, most unemployment observed at any given time is long-
term.

This subtle conclusion implies that economists and policymakers must be careful when
interpreting data on unemployment and when designing policies to help the unemployed.
Most people who become unemployed will soon find jobs. Yet most of the economy‟s

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unemployment problem is attributable to the relatively few workers who are jobless for long
periods of time.

We have discussed how we measure the amount of unemployment, the problems that arise
in interpreting unemployment statistics, and the findings of labor economists on the duration
of unemployment. You should now have a good idea about what unemployment is. This
discussion, however, has not explained why economies experience unemployment.

In most markets in the economy, prices adjust to bring quantity supplied and quantity
demanded into balance. In an ideal labor market, wages would adjust to balance the quantity
of labor supplied and the quantity of labor demanded. This adjustment of wages would
ensure that all workers are always fully employed. If there is unemployment at all, it must be
voluntary unemployment – unemployment, at an equilibrium wage rate, caused by members
of the labor force refusing to take jobs offered.

Of course, reality does not resemble this ideal. There are always some workers without jobs,
even when the overall economy is doing well. In other words, the unemployment rate never
falls to zero.

2.2 Types of Unemployment

There are groups of individuals who are unable to obtain employment at a given wage rate,
constituting involuntary unemployment. Keynes was particularly noted for identifying this
type of unemployment, partly because he prescribed an increase in aggregate demand to
eliminate it.

We now examine the reasons why actual labor markets depart from the ideal of full
employment. In classical economics, unemployment is viewed as a temporary phenomenon
until price flexibility restores an economy to full employment. That is, classical economists,
with their belief that all markets ultimately clear, believed that unemployment was a short

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term phenomenon of a frictional type. Keynes challenged the classical view and later
economists have been skeptical about the clearing of markets. Keynes insisted that
unemployment could be involuntary, as a consequence of a deficiency in demand.

Frictional unemployment is a short-period unemployment brought about by job quits, job

switches (workers changing jobs), and new entrants and reentrants into the labor force. Or,
frictional unemployment is temporary and occurs when a person quits a current job before
securing a new one, is not immediately hired when entering the labor force, or is let go by a
dissatisfied employer. This type of unemployment, which coexists with job vacancies,
occurs even when an economy is at full employment and is a feature of all types of national
economy.

Search unemployment (we saw in Section 1.1) is an important source of frictional

unemployment. Labor market policies can reduce this type of unemployment by making job
information more available and accurate and by subsidizing search costs.

Another source of frictional unemployment is wait unemployment. In some instances,

unemployed workers willingly wait to be recalled from temporary layoffs or willingly wait
in job queues to obtain union jobs. Additionally, efficiency wages may attract (potential)
workers into the labor force who are forced to wait for such jobs to open.

Structural unemployment is unemployment caused by a difference between the structure of

employment vacancies and the structure of unemployment, usually brought about by
technological change. Unemployed persons have different skills from those being demanded
by employers or are located in a different place from a potential employer. Workers who
lose their jobs due to a change in the demand for a particular commodity or because of
technological advance (and the implied job cutbacks) are structurally unemployed. Their
unemployment normally lasts for a longer period since they usually possess specialized
skills which are not demanded by other employers. Critics of this concept regard it as only a
case of extreme frictional unemployment.

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Educational subsidies that reduce the investment costs of obtaining human capital, and
programs designed to provide skills to those structurally unemployed (through training and
retraining) are among the alternatives governments use to solve the problem of structural
unemployment.

Cyclical unemployment is recurrent unemployment occurring at particular phases of the

business cycle, starting with the downturn from a boom. Workers have the necessary skills
and are available to work, but there are insufficient jobs because of inadequate aggregate
spending. Cyclical unemployment occurs when real GDP falls below potential GDP. This
unemployment is the result of insufficient aggregate demand accompanied by downward
inflexibility of wage rates.

Wage rates are downward inflexible because of a variety of reasons. Unions are one reason
why nominal wages are rigid downwards. Unions prefer temporary layoffs (of some
workers) to wage reductions which affect all workers. Secondly, firms themselves may favor
temporary selective layoffs to across-the-board (even temporary) wage reductions. Because
across-the-board wage reductions may cause higher-skilled, more-experienced workers in
whom a firm has invested large amounts of training to quit and take jobs elsewhere.

A third reason for downward wage rigidity (during recessions) is that implicit contracts
govern many employment relationships. Implicit contracts are informal, often unstated,
understandings that are invisible hand shakes. This is an informal understanding between an
employer and workers whose terms are not legally binding because of their implicit nature.
Employers make such tacit agreements as part of their pursuit of long-term profitability. An
employment contract is incomplete because it omits reference to work effort and so an
employer has to monitor the contract to achieve the exchange of a “fair day‟s pay” for a “fair
day‟s work”.

Finally, downward wage inflexibility may be explained by Insider-Outsider Theories.

Insiders are employed workers who have some degree of market power; outsiders are

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unemployed persons who are unable or unwilling to underbid the existing wage rate to gain
employment. Outsiders may not be able to bid down the wage rate because firms may view
the cost of hiring outsiders as prohibitive. Firms may expect that, upon hiring outsiders at
less than the existing wage rate, the remaining incumbent workers will withhold cooperation
from those who “stole” jobs, and this may hurt the firms‟ output and profits. Even if firms
were willing to hire outsiders, outsiders may be unwilling to offer their services for less than
the present wage rate for fear of being harassed by remaining incumbent workers. Outsiders
may thus opt to wait for an increase in aggregate demand to obtain or regain employment.
Meanwhile, cyclical unemployment persists.

The cyclical unemployment rate can be negative when real GDP exceeds potential GDP and
the economy is producing beyond its normal full-employment level. This negative cyclical
unemployment rate indicates that the normal job search period for the frictionally and
structurally unemployed is shortened because of an abnormally large number of job
openings.

Cyclical unemployment imposes costs upon both society and the person unemployed.
Society‟s opportunity cost is the amount of output which is not produced and therefore is
lost forever. The personal costs that occur during an economic downturn are unevenly
distributed between different types of workers.

Full employment exists when there is no cyclical unemployment but normal amounts of
frictional and structural unemployment; thus, full employment exists at an unemployment
rate greater than zero. This is referred to as the natural rate of unemployment. It may change
when there is a change in the normal amount of frictional and structural unemployment.

Governments usually try to reduce cyclical unemployment by using expansionary fiscal

and/or monetary policy, which increase aggregate demand. However, attempts to move the
economy to a lower rate of unemployment by fiscal and monetary stimulation are

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unsuccessful as expectations increase leading to inflationary increases in prices and wages
which push the unemployment rate back to the natural rate.

Section Reflection

1. How is the unemployment rate measured? How might the unemployment rate overstate
the amount of joblessness? How might it understate it?
2. What are the differences between the classical and Keynesian views of unemployment
3. Distinguish among frictional, structural, and cyclical unemployment. Give an example
for each.
4. Draw the supply curve and the demand curve for a labor market in which the wage is
fixed above the equilibrium level. Show the quantity of labor supplied, the quantity
demanded, and the amount of unemployment.

Unit Summary

1. Job search is the process of matching workers with appropriate jobs, and is a natural and
often constructive occurrence in a dynamic economy characterized by heterogeneous
workers and jobs and by imperfect information.

2. If the job seeker is offered a wage rate above this acceptance wage – the wage that
equates the expected marginal benefit (MB) and expected marginal cost (MC) from
search – he/she will conclude that it is not worthwhile to continue searching (MB <
MC).

3. Most firms and plants embody internal labor markets in which wages and the allocation
of labor are determined by administrative rules and procedures rather than strictly by
supply and demand (the notion of auction markets).

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4. Unemployment refers to the state of being part of a labor force, wanting to work, but
without a job. Frictional unemployment is a short-period unemployment brought about
by job quits, job switches (workers changing jobs), and new entrants and reentrants into
the labor force. Structural unemployment is unemployment caused by a difference
between the structure of employment vacancies and the structure of unemployment,
usually brought about by technological change. Cyclical unemployment is recurrent
unemployment occurring at particular phases of the business cycle, starting with the
downturn from a boom; workers have the necessary skills and are available to work, but
there are insufficient jobs because of inadequate aggregate spending.

5. Labor market policies can reduce frictional unemployment resulting from job searches
by making job information more available and accurate and by subsidizing search costs.
Similarly, educational subsidies that reduce the investment costs of obtaining human
capital, and training and retraining programs designed to provide skills to those
structurally unemployed can be used to solve the problem of structural unemployment.
Attempts to move the economy to a lower rate of unemployment – directed at fighting
cyclical unemployment – by fiscal and monetary stimulation are unsuccessful as
expectations increase leading to inflationary increases in prices and wages which push
the unemployment rate back to the natural rate.

Review Questions

I. For Each of the Following Questions, Choose the Correct Answer

1. Internal labor markets:

A. may enhance productivity by reducing recruitment, screening, and training costs.
B. may enhance productivity by inducing senior workers to share their skills and
knowledge with junior workers.
C. may enhance productivity by enhancing younger workers with greater incentives to
work productively.

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 D. may contribute to inefficiency as wages are determined by rigid administrative
procedures and rules.
E. All are true.
2. Which of the following provides a reason for downward inflexible nominal wages?
A. Presence of unions
B. Implicit contracts
C. Insider-outsider relationships
D. Firms‟ bias toward layoffs (as compared to across-the-board wage reductions)
E. All

II: For Each of the Items under Column A, Choose the Match from the
Items under Column B.

A B
3. External labor market A. Structural unemployment
4. Demand-deficient unemployment B. Job ladders
5. Internal labor market C. Frictional unemployment
6. Search unemployment and job switches D. Auction market
7. Displaced workers and job cutbacks E. Cyclical unemployment

III. Answer Each of the Following Questions

8. Why is frictional unemployment inevitable? How might the government reduce the
amount of frictional unemployment?
9. Why is the unemployment rate an imperfect measure of joblessness?
10. “Unemployment insurance is a government policy that, while protecting workers‟
incomes, increases the amount of frictional unemployment.” Do you agree? Why or
why not?

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ANSWERS TO SELECTED REVIEW QUESTIONS

UNIT TWO 4 C
1 A 5 D
2 C 6 E
3 B 7 False
4 A 8 True
5 B 9 False
6 D 10 False
7 True
8 True UNIT FIVE
9 False 1D
10 True 2E
3 True
UNIT THREE 4 True
1 D 5 False
2 C 6 True
3 A 7C
4 D 8A
5 C 9B
6 C 10 D
7 C
8 D UNIT SIX
9 C 1 E
10 D 2 E
3 D
UNIT FOUR 4 E
1 D 5 B
2 A 6 C
3 B 7 A

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Bartley, A. (2003). (ed.). Schaum’s Easy Outlines Principles of Economics. McGraw-Hill.
Borjas, G. (2005). Labor Economics, 3rd edition. McGraw-Hill.
Chirinko, R. and D. Mallick. (2006). the Elasticity of Derived Demand, Factor Substitution,
and Product Demand: Corrections to Hicks' Formula and Marshall's Four Rules
Hassen Abda. (2009). Microeconomics II: A Teaching Material. Jimma University.
(unpublished)
Koutsoyiannis, A. (1981). Modern Microeconomics, 2nd edition. St Martins Pr.
McConnell C., S. Brue and D. Macpherson. (2003). Contemporary Labor Economics, 7th
edition. McGraw-Hill, Irwin.
Rutherford, D. (2002). Routledge Dictionary of Economics, 2nd edition. Taylor and Francis
Group: London and New York.

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